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Edited Transcript of LOW earnings conference call or presentation 22-May-19 1:00pm GMT

Q1 2019 Lowe's Companies Inc Earnings Call

Mooresville Jun 4, 2019 (Thomson StreetEvents) -- Edited Transcript of Lowe's Companies Inc earnings conference call or presentation Wednesday, May 22, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David M. Denton

Lowe's Companies, Inc. - Executive VP & CFO

* Joseph Michael McFarland

Lowe's Companies, Inc. - EVP of Stores

* Marvin R. Ellison

Lowe's Companies, Inc. - President, CEO & Director

* William P. Boltz

Lowe's Companies, Inc. - EVP of Merchandising

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Conference Call Participants

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* Brian William Nagel

Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst

* Christopher Michael Horvers

JP Morgan Chase & Co, Research Division - Senior Analyst

* Michael Lasser

UBS Investment Bank, Research Division - MD and Equity Research Analyst of Consumer Hardlines

* Siddharth Deepak Dandekar

Wolfe Research, LLC - Research Analyst

* Simeon Ari Gutman

Morgan Stanley, Research Division - Executive Director

* Zachary Robert Fadem

Wells Fargo Securities, LLC, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good morning, everyone, and welcome to Lowe's Companies' First Quarter 2019 Earnings Conference Call. This call is being recorded. (Operator Instructions) Also, supplemental reference slides are available on Lowe's Investor Relations website within the investor packet. While management will not be speaking directly to the slides, these slides are meant to facilitate your review of the company's results and to be used as a reference document following the call.

During this call, management will be using certain non-GAAP financial measures. The supplemental reference slides include information about these measures and their 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.

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [2]

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Thank you, Regina. Good morning, everyone. Our first quarter comp performance is a true indication that our focus on retail fundamentals is gaining traction. Despite solid top line results, our gross margin performance in Q1 highlights that we still have work to do as we continue our transformation. We've taken the necessary short- and long-term actions to improve our gross margins, which I'll discuss in more detail in a moment, but first, let me highlight what drove our sales performance in Q1 specific to our commitment to improving in-stock and customer service, coupled with our focus on winning the pro are keys to our improved sales performance.

For Q1, we delivered total company comps of 3.5%, and our U.S. home improvement comps grew 4.2% for the quarter. While it was challenging earlier in the quarter, given that we experienced the second wettest February on record. In fact, unfavorable weather exerted 315 basis points of top line pressure in February.

As Lowe's improved, we saw broad-based sequential improvement with comps of a negative 1.4% in February, positive 3.5% in March and positive 7.2% in April. We drove increased traffic to stores and to Lowes.com and generated a more balanced top line growth with increasing transactions by 2.2% and increasing average ticket by 1.3%.

We delivered positive comps in 10 of 13 merchandising departments, including double-digit comps in seasonal and outdoor living and high single-digit comps in lawn and garden. We drove positive comps in all geographic regions with the exception of Tampa and Houston, which faced tough prior year comparisons of Hurricanes Irma and Harvey. For Q1, some of our best-performing geographic regions were Atlanta, Charlotte, Los Angeles, Nashville, New York Metro, Pittsburgh, Philadelphia and Richmond.

Our pro comps significantly outperformed DIY, and we see early evidence that our strategic initiatives with this very important customer are gaining traction. And Joe McFarland will add additional color to our pro performance later in the call.

For Lowes.com, we posted comp growth of 16% for the quarter. Although we're still not where we like to be with our online business, I'm pleased with the progress our new leaders are making to improve the infrastructure of this very important channel. In Canada, we posted negative comps for the quarter as the weaker Canadian housing market exerted pressure on the business.

Adjusted diluted earnings per share were $1.22 for the quarter, and a convergence of factors led to gross margin pressure in the quarter. Some of these challenges are a reflection of the tools and process limitations I've discussed on previous calls. But what's important is that we have our arms around the issues and have plans to improve gross margin over the course of the year.

But allow me to take a moment to outline the factors that led to our Q1 gross margin shortfall. First, we recognized inventory first in, first out. So cost increases that were agreed to by merchants in 2018 are now flowing through the P&L as we turn inventory, the majority of these cost increases that were accepted in 2018 without any corresponding offset to gross margin pressure.

Second, as we are preparing and we're preparing for the business' seasonal year, we undertook unprecedented levels of change in our merchandising organization. Over the past 6 months, we replaced 2 of our 3 merchandising senior vice presidents and we replaced 11 of our 13 merchandising vice presidents. This level change was necessary to ensure that we have the best talent in position to plot our strategy for the second half of the year, spring of 2020 and to fuel our future growth.

However, as we transitioned from legacy merchants to new merchants, there was much more disruption in Q1 than we anticipated, and this disruption was primarily driven by a lack of visibility in our pricing ecosystem. Our new merchants simply did not have clear line of sight to the cost increases that were accepted by prior merchants as we transitioned.

Based on the really limited systems visibility, we could not quickly analyze and offset these cost increases with appropriate pricing action. Our challenge with pricing tools and processes aren't new to Lowe's. However, we did not anticipate the impact of fully communicated cost increases, significant organization changes with 11 new merchandising VPs and legacy ineffective pricing tools and processes.

Now let me take a moment and outline the decisive actions we're taking to improve our gross margin for the balance of 2019. First, our CIO, Seemantini, is leading an effort to implement changes to our pricing and point-of-sale systems. With these changes, we will streamline who can affect costs and pricing changes and sequence those pricing actions to prioritize those that have the greatest impact to gross margin. We'll also have better visibility for the merchants to understand the impact of all pricing actions without having to view multiple systems and numerous reports. We're establishing a more efficient process to systemically analyze, prioritize and implement pricing actions to offset cost pressure.

Second, our recent acquisition of Boomerang's retail analytics platform, a leading pricing analytics practice, is a significant step forward towards modernizing our approach to pricing by digitizing our business processes and increasing our agility. This acquisition reflects our commitment to modernizing our systems and reinforces our philosophy to buy-versus-build capabilities if that approach is more advantageous for the company.

And finally, as our merchant leaders accrue more time in their roles, they have better view of the categories and assessment plans, and stability in any organization is important, and now we have that stability for the balance of 2019 in our merchandising organization. With enhanced visibility, the merchants are better able to offset cost pressure with adjusting prices within their portfolio of products.

In addition, we're building improved pricing analytics to help offset future cost pressure and protect gross margin and impact the top line sales. It's important to mention that we believe our pricing issues hurt top line sales as well as gross margin in Q1. By not taking pricing action on our inelastic SKUs to offset cost increases, we simply decremented top and bottom line at point-of-sale, which we believe negatively impacted sales.

As I've discussed on previous calls, this is a multiyear transformation, and we're in the Phase 1 of a 3-phase process. However, our first quarter results clearly reflect 2 things. First, our 4.2% comp in the U.S. clearly illustrates that customers are responding to our changes and our approach to retail fundamentals is working. From my experience, there are 3 things you hope to see during the early stages of a transformation. You want to see positive customer transactions. You want to grow average ticket while reducing expense and improving efficiencies to leverage SG&A. We saw all 3 in Q1, which gives us confidence that we're taking the right strategic steps.

Our first quarter also reflects that as we encounter systems and process limitations during this transformation, we now have the experience and the internal expertise to address the issues and minimize the impact on future periods. The issues that impacted Lowe's gross margin in Q1 have been identified and are being addressed with process changes and system adjustments. Consequently, we expect to deliver improved gross margin performance over the balance of the year.

We made a lot of progress, but our transformation is clearly ongoing. Our first quarter comp and our improved sales for productivity, driven in large part by the pro customer, gives us confidence that our strategy is working. And we're committed to making the investments and taking the actions necessary to address legacy issues and position Lowe's for sustainable long-term sales and profit growth.

My most enjoyable time as CEO is the weekly visits I spend in the stores. Our associates have demonstrated to me their passion for our customer and for this great company. So before I close, I would like to thank them for their hard work and their commitment to serving the customers and serving our communities. And with that, I'll turn the call over to Bill.

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William P. Boltz, Lowe's Companies, Inc. - EVP of Merchandising [3]

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Thanks, Marvin, and good morning, everyone. As Marvin shared with you, we capitalized on spring demand in the first quarter, posting U.S. comparable sales growth of 4.2%. We transitioned into the spring season more efficiently. We began setting our stores from south to north 3 weeks earlier than last year, and we adjusted our store inventory load-in to 60% versus 35% last year. These actions ensured that we were ready for the spring season and positioned us to have adequate seasonal inventory on hand to capture that spring demand.

Our teams also significantly improved sales for productivity through better use of end caps and a redefined strategy for off-shelf side stacks. We leveraged our spring Black Friday event to take advantage of seasonal project demand with strong messaging and attractive offers, more personalized marketing and a continued shift into digital and localized marketing channels. And as Joe will share with you in a moment, our associates delivered very well in the aisles and executed a very successful event.

Our success in driving strong spring sales was supported by the improved service model in our stores and a better in-stock execution. For the quarter, we achieved double-digit comps in seasonal and outdoor living, led by double-digit comps in outdoor power equipment, where we continue to leverage the top 3 brands in riding equipment with John Deere, Husqvarna and CRAFSTMAN. We also drove double-digit comps in grills through our offers from Weber and Char-Broil, the top 2 brands in outdoor grilling.

In addition to seasonal and outdoor living, we also delivered high single-digit comps in lawn and garden, with the strength in our lawn care and landscape products through the power of the Scott's brand, and in live goods with our nationwide body plant offers, along with the extension of our Monrovia plant program, a home center exclusive.

In the first quarter, we also saw strength in our tools and our appliance businesses. We have posted above-average comps and tools as the CRAFSTMAN reset continues to drive strength in categories like tool storage and mechanics tools. We're excited to be able to complete the CRAFTSMAN tools reset by the end of the second quarter, and we look forward to introducing the brand into additional categories in the second half of the year. The CRAFTSMAN brand, along with our proprietary Kobalt brand, continues to drive traffic, and they both create a loyalty-building opportunity for us. We are proud to be able to offer both brands and with the exclusive destination of the home center channel for the CRAFTSMAN brand.

We also drove above-average comps in appliances as we continue to leverage our leading market share position through our top brands, our breadth of assortment and our strong events. Though paint performed below the company average, the category still delivered positive comps even with the significant weather pressure early in the quarter.

Our intense focus on our retail fundamentals, while leveraging our exclusive partnership with Sherwin-Williams, has allowed us to continue to drive progress in this category. And as Marvin indicated, we are in the early stages of implementing change, which did create some disruption in Q1.

However, I'm very pleased with the talent and the deep retail experience we've been able to recruit and to infuse throughout our merchandising organization. Our new leaders are now firmly established in their roles, and we expect this leadership stability to drive sustainable improvement for the balance of 2019 and beyond.

We are encouraged by the early results that we are seeing from our new merchandising service team. These teams are supported by our vendors, and they are responsible for the day-to-day bay maintenance and resets in our stores, along with setting and maintaining end caps and help executing off-shelf displays.

The MST teams are a critical component to improving our merchandising reset execution at store level as they take these important and time-consuming tasks off the shoulders of our red vest associates, so that they can be freed up to serve our customers.

The early results of our MST program show reductions in out of stocks and improved sales productivity and an increase in bay service per hour. The MSTs also provided critical support during our successful spring Black Friday event as well as for our CRAFTSMAN outdoor power equipment and tools reset.

As Marvin stated, we were very pleased with our pro business in Q1, and we are focused and leveraged on our improved in-stock position along with our key brands to drive additional sales with this very important customer.

As an example, in the first quarter, we announced that Little Giant Ladder Systems, a leader in safety and innovation, has chosen Lowe's as their exclusive home center partner. Our teams continue to work to add more key programs to our assortments as well as leveraging our existing partnerships with brands such as Dewalt, the #1 power tool brand in the industry, and the new and innovative products we have from Bosch and Metabo HPT that are all focused on saving the pro both time and money.

In the first quarter, we also took steps to driving merchandising productivity and localization through the investment and rollout of our field merchandising teams. The teams are now in place, and we expect to see the continued benefits from their work with our merchants and our stores in the second half of 2019.

As we look ahead to Q2, we remain focused on carrying our momentum forward. We expect to drive sales and traffic with our compelling Memorial Day, Father's Day and July 4 events, the power of CRAFTSMAN as we complete the rollout of our CRAFTSMAN tool program and our pro categories as we continue to capitalize on our job lot quality investments and are focused on this very important customer segment. We also remain focused on driving improved growth on Lowes.com as we work to increase our online assortments, continue to improve the shopping experience and work to ship slower-moving SKUs out of our stores and on to our website to improve inventory productivity.

We are excited about the opportunities that are ahead of us, and we're working very hard to position Lowe's for the future and to capitalize on the strong demand in the healthy segment. Thank you, and I'll now turn the call over to Joe.

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Joseph Michael McFarland, Lowe's Companies, Inc. - EVP of Stores [4]

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Thanks, Bill, and good morning, everyone. As Marvin indicated, our commitment to improving in-stocks and customer service, along with our focus on winning the pro, were keys to our improved sales performance in the first quarter.

To improve associate engagement, we rolled out smart model, a new customer service model which guides the way we hire, train, evaluate and coach our associates. This program models with a great experience that actually looks like and drives behaviors that deliver the kind of experience that customers want. It includes a comprehensive tool kit, training program and mobile devices, which are designed to provide our associates with the tools they need to deliver outstanding customer service.

In the first quarter alone, we trained over 280,000 associates on smart customer service. And we also rolled out approximately 88,000 smart mobile devices to our stores. Associates are no longer required to leave the sales floor to log into a terminal to determine the price, availability or order status of an item. The new smart device reduced tasking hours by providing associates with real-time data without ever stepping off the sales floor.

For example, the smart devices have functionality to process bottom line pick up in store orders. This new functionality takes us from a 12-step, paper-based process to an average of 2 digital scans. In the first quarter, 60% of our online purchases were picked up in our stores, which reinforces the power of our omnichannel model. The rollout of smart devices and the systematic improvements in buy online, pick up in store represents a significant advancement in the partnership between our stores and IT, and are really terrific early examples of what we can accomplish as an organization when we are focused in the line.

To further improve the customer experience, in the first quarter, we replaced a series of nonfacing customer positions with over 6,000 assistant store managers and department supervisors. These customer-facing store leadership roles are focused on providing better departmental coverage and expertise as well as coaching our associates in delivering excellent service.

Previously, for example, a single department supervisor was tasked with covering the lawn and garden, rough plumbing and electrical and paint department simultaneously, which simply isn't manageable. With the addition of department supervisors, we're ensuring that we have the proper coverage for strategic areas of focus such as paint. To that end, one of the incremental supervisors is dedicated to the pro department.

As we have discussed, the pro customer is a key focus for us in 2019. In the first quarter, we were very pleased with our sales and customer service improvements in pro. This improvement was driven by executing 5 key steps. First, we addressed our out-of-stock issues and poor inventory presentation with a commitment to improving our job lot quantities and our product presentation under the pro canopy and on our end caps.

Second, we improved our store level service to ensure we can get our pro customers in and out faster. This included adding dedicated loaders and establishing preferred parking under the canopy. Remember, for the pros, time is money.

Next, we staffed our pro desks with dedicated associates, working a consistent schedule, and we added department supervisors to all pro areas of our store. We redesigned our field structure, adding 15 new regional pro managers, and recruited experienced leaders to focus on our in-store and outside pro sales.

Then finally, we worked with Bill and the merchandising team to communicate a consistent volume pricing message and improved our product presentation in the area.

After we felt comfortable with the execution of these 5 steps, we invited customers then to share our improved environment with a very successful and nationally marketed pro appreciation event, which allowed us to grow our pro accounts. In fact, we opened over 40,000 new pro accounts in the first quarter.

We also leveraged our exclusive partnership with the NFL. We ran pro-focused national advertising during the NFL draft. This was an extension of our do it right for less campaign, reinforcing that Lowe's offers the job site delivery and job lot quantities pros need as well as designated pro supervisors equipped to help our customers.

Although we are pleased that our first quarter pro comp significantly outperformed our DIY comp, we are still in the early stages of our transformation with this customer. I look forward to discussing additional initiatives for the pro in upcoming calls.

In closing, to improve staffing and further leverage our payroll spend, in the second quarter, we'll continue the rollout of our new customer-centric labor scheduling system. This system will better predict customer demand by time of day, day of week and department, allowing us to align our labor hours with peak traffic, providing better department coverage and customer service while ensuring that we're using our labor hours efficiently and reducing our overall payroll expense. This new system will replace our current staffing system that doesn't effectively capture and predict sales and customer traffic patterns. We'll have this new system fully rolled out in the second half of this year.

Though we are in the beginning stages of change, we are excited about the early results we're seeing and committed to the work ahead to fully capitalize on the healthy demand in our sector. Thank you, and I will now turn the call over to Dave.

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [5]

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Thanks, Joe. Good morning, everyone. Let me begin this morning with just a few housekeeping notes.

First, as disclosed in our press release, this quarter, we adopted the new lease accounting standard using a prospective transition approach. The adoption of the standard resulted in an increase in lease-related assets of $3.6 billion and an increase in lease-related liabilities of $3.9 billion. The difference between the increases in lease-related assets and liabilities, net of deferred tax impact, was reported as an adjustment to beginning retained earnings. The standard had no impact on our debt covenant compliance under our current agreements.

Second, as also described in our press release, in the first quarter, we realized a tax benefit in connection with our previously announced decision to exit our Mexico operations. We had originally planned to sell the operating business. However, in the first quarter, after an extensive market evaluation, we decided to instead sell the assets of this business. That decision resulted in an $82 million tax benefit, which offset $12 million of pretax operating costs for the Mexico operations within the quarter.

With that, I'll turn to a review of our operating performance starting with our capital allocation program. In the first quarter, we generated over $1.9 billion in free cash. And through a combination of both dividends and share repurchases, we've returned over 60% of this cash to our shareholders.

In the first quarter alone, we paid $385 million in dividends, and our dividend payout ratio currently stands at 37%. We also entered into a $350 million accelerated share repurchase agreement retiring approximately 3.2 million shares and repurchased approximately 4.4 million shares for $468 million throughout -- through the open market.

So in total, we've repurchased $818 million of our stock at an average price of $107.60. We have approximately $13.1 billion remaining on our share repurchase authorization.

In April, we issued $3 billion of unsecured bonds. The issue was consistent of 10- and 30-year notes with a weighted average interest rate of 4.1%. The proceeds of this issuance were used to refinance current year maturities and other general corporate purposes.

And we continue to invest in our core business with capital expenditures of approximately $205 million in the first quarter.

Now looking at the income statement. We generated GAAP diluted earnings per share of $1.31 per share compared to $1.19 in the first quarter of last year, an increase of 10.1%. On a comparable basis, excluding the $82 million tax benefit and $12 million of pretax operating costs to Mexico, adjusted diluted earnings per share was $1.22, an increase of 2.5% compared to LY.

As Marvin indicated, though we are very pleased with our sales performance, we experienced significant gross margin contraction, which resulted in lower-than-expected earnings per share in the quarter, which I'll discuss in more detail in just a moment.

Sales for the first quarter increased 2.2% to $17.7 billion, supported by total average ticket growth of 2.9% to $77.19, partially offset by a slight decline in total transactions. Comp sales were 3.5%, driven by a comp transaction increase of 2.2% and an average ticket increase of 1.3%. Our U.S. comps was 4.2% for Q1.

So looking at monthly trends, total comps were negative 1.4% in February, positive 3.5% in March and positive 7.2% in April. Additionally, monthly comps for our U.S. business were negative 0.9% in February, a positive 4% March and a positive 8% in April.

Now if you were to adjust for the impact of commodity deflation along with weather in February, our U.S. comps would have been approximately 5.7% for the quarter.

Gross margin for first quarter was 31.5% of sales, a decrease of 165 basis points compared to Q1 of last year. We experienced approximately 90 basis points of pressure from the challenges with our pricing ecosystem that Marvin discussed earlier. The tools and process issues have been identified and are being addressed to mitigate this pressure going forward.

As expected, we also experienced approximately 40 basis points of pressure from supply chain costs as we added new facilities to the network that are still ramping up to full capacity, coupled with ongoing increases in transportation costs and customer deliveries.

Product mix shift had approximately 30 basis points of negative impact on gross margins also in the quarter.

SG&A for Q1 was 21.8% of sales, which levered 89 basis points. We drove 80 basis points of leverage in retail operating salaries and 17 basis points of leverage through improved advertising efficiency.

We also had 34 basis points of leverage from lease assignments and terminations associated with last year's store closing activities. These items were partially offset by deleverage in incentive compensation and employee insurance.

Operating income decreased 45 basis points to 7.99% of sales.

The effective tax rate was 16.6% compared to 24.3% last year. This significant improvement year-over-year is primarily due to the favorable tax benefit associated with the change in approach to exiting our Mexico operations. On a comparable basis, our adjusted effective tax rate was 22.9%.

At $15 billion, inventory increased $1.8 billion or 13.8% versus the first quarter of LY. This is largely driven by inventory to support anticipated seasonal demand, adjusted presentation minimums and investments in job lot quantities.

Albeit a significant increase in inventory, these are important strategic investments to drive sales performance in the coming months.

Now before I close, let me address our 2019 business outlook, which has been updated to reflect our gross margin miss to plan in the first quarter and to adjust the remainder of the year for the expected timing and impact of our corrective actions.

For 2019, we still expect a total sales increase of approximately 2% for the year, driven by a comp sales increase of approximately 3%. However, we now expect adjusted operating margin to increase 20 to 50 basis points.

The effective tax rate is expected to be approximately 24%, and so we now expect adjusted diluted earnings per share of $5.45 to $5.65.

We are now forecasting operating cash flow of approximately $4.5 billion as a result of our lower operating margin expectations and an increase in inventory versus our plan. CapEx is still expected to be approximately $1.6 billion, and this is expected to result in free cash flow of approximately $3 billion for 2019.

Our target leverage ratio remains at 2.75x. So with that, our guidance now assumes approximately $4 billion in share repurchases for the year.

Now as Marvin mentioned, we're early in our transformation, but we now have a management team in place with the expertise required to tackle the opportunities ahead of us. With the sales momentum we gained throughout the first quarter, we remain extremely excited about the future of our business, and we're focused on taking the necessary actions to both improve our performance and drive long-term shareholder value. And with that, we're now ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Michael Baker with Deutsche Bank.

Our next question will come from the line of Scott Mushkin with Wolfe Research.

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Siddharth Deepak Dandekar, Wolfe Research, LLC - Research Analyst [2]

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This is Sid on for Scott. You mentioned 90 basis points of gross margin contraction from the pricing system issue. It sounds like some of these things like the FIFO inventory and the merchandising issues, they were probably -- you had some insight to that coming into the quarter? Just trying to understand how much of that was expected versus completely unexpected.

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [3]

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I'll take the first part of that. It was primarily unexpected. As I mentioned, we see and view our inventories first in, first out, and we had cost increases that were taken in 2018 with no offsetting steps to protect gross margin, which obviously was not a great decision. Because of the limitations within our system and the transition of our merchandising team, we literally had no visibility to those cost increases until the inventory that was increased in costs started to hit the P&L as it layered and sold through with inventory turns. So our legacy systems really gave our merchants and our finance team limited visibility to these changes until it literally hit the P&L. So we did not have an expectation this was going to happen.

The good news is that we've upgraded our systems to provide better visibility to costs and retail pricing actions. We now have the ability to prioritize which pricing actions to take. And as Dave mentioned, we've taken mitigative steps and actions to address this. Where we have made the changes, some pricing actions, we feel good about the year-over-year performance in our gross margin. We're just continuing to work through the issue. And again, it was not something we planned coming into the quarter.

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Siddharth Deepak Dandekar, Wolfe Research, LLC - Research Analyst [4]

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All right. And then just one follow-up for Dave. It looks like the 6x rent calculation that you had in your leverage ratio target prior to this new standard was understating the operating lease adjustment, which is now actually on the balance sheet. So given you ended 1Q with the leverage so close to your target, are you foreseeing any modification of the target going forward, some wiggle room in your capital allocation strategy for the year?

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [5]

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Sid, I think if you look at that number, it changed only modestly. So I think that our estimates were pretty spot on from that perspective. And we do not anticipate change in our cap structure of 2.75x based on that adjustment.

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Operator [6]

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

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Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [7]

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So just to clarify, this GM weakness, this was not driven by promotion. This was bad systems. There was some execution. And by the logic you provided on the call, where you didn't get higher prices on inelastic items, you didn't mention elastic goods. Because by that logic, if you didn't push higher prices on elastic goods, why is that different from being promotional or even discounting?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [8]

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So this is Marvin. I'll take your question. From a promotional cadence, it was consistent with last year. So this was not driven by increased promotions. As a matter of fact, we believe strongly that not only did this dilute gross margin, but it also diluted sales. So our pricing architecture, we look at it head, core, tail. Head items are items that are price-sensitive, most often scraped by our competitors, where we have to be price-competitive. And so we're going to be competitive on those head items. Typically, what happens, if you receive a cost increase, you're not going to increase your retails of your head items because it makes you nonprice-competitive. So that does not happen. Instead, what you do is you find items that are inelastic within that same assortment, and you make the adjustments there. We didn't make any adjustments, nor did we promote lower prices. So we just basically decremented margin at point-of-sale and we decremented top line at point-of-sale as well. Our promotional cadence was the same. We desire to be less promotional, not more promotional. And again, our promotional strategy was a lot different from last year in terms of days, offers or inventory.

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Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [9]

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Got it, okay. I guess my follow-up then is separating out the actual execution from these -- from fixing this from the accounting. So it seems like you're making changes now. If not, a lot of those are being made or have been made. How does that flow? Why -- does it take time? I guess, it flows through the rest of the year? Or we should be -- should we recoup this by the time we get to the end of 2019? Or is this a 2020 recoup?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [10]

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So I'll take the first part of that, and I'll let Dave provide any additional context. So as I discussed and Dave mentioned, this was worth about 90 basis points. And again, each of [them] has visibility, we didn't know this was going to start hitting the P&L. To be quite candid, some of these cost increases were taken 40 or 50 weeks ago and without any mitigating actions I mentioned to offset gross margin. So as we work through making these adjustments, where we have implemented pricing action to gross margin (inaudible) versus last year, which is (inaudible). If we're taking additional taking strategic pricing actions that (inaudible) impacted 2019, we're confident it's working. We typically are taking the time to analyze the results to make sure that we understand the full benefit to '19. And because of that, we felt it prudent to update the guidance because this is an ongoing effort. So that's the operational execution side of it.

And the good news is the partnership between finance, merchandising, led by IT, we have significantly better visibility to all pricing actions, to cost increases. We have now one team responsible for approving and managing our cost and retail increases. We also have a very basic retail philosophy. That is if you accept the cost increase, you need to take mitigating steps to offset gross margin. That's not unique in retail, but it was unique to Lowe's until Q1. So we now have our arms around this, and that's the operational execution side of it. And I'll let Dave speak to any of the accounting side.

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [11]

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Yes. So maybe I'd like to step back and give a little color on our guidance and kind of lay it out as we cycled into Q1. As we look very near term from a Q1 sales performance, we continue to see that consistent with our expectations. And our gross margin trends, as we cycle into Q2, are materially consistent with what we've seen in Q1. However, as Marvin indicated, in the areas we have taken pricing actions, we have began -- we have just begun to see some improvement performance versus trend and versus OI. And our guidance reflects the fact that we still need to implement more actions. And quite honestly, we need more time to make sure that we analyze and fully understand the net effect of all the changes that we are currently implementing. So you're going to see this improvement bleed also into Q2, but importantly into 3 and 4. And I think we won't see major trends inflection in Q2 as much as we'll see in 3 and 4 as we bleed this inventory, these pricing actions through our system, as we're currently doing as we speak.

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Operator [12]

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

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Michael Lasser, UBS Investment Bank, Research Division - MD and Equity Research Analyst of Consumer Hardlines [13]

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Can you give us more specifics on what categories the price increases that you experienced are in? And why can you not remediate or address this issue until the second half of the year? Why can't you just peak price increases on those inelastic goods right now?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [14]

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So, Mike, I'll take the first part of that, and I'll let Bill jump in if he has any additional color. It is rather widespread because some of the categories that these actions were taken in. Quite candidly, we're trying to understand the logic of the cost increases across multiple categories. The good news is we now have visibility to what they were, and we're putting the processes in place to go back and correct those issues. As you can appreciate, Michael, we're in a very competitive environment. And so we just can't go out arbitrarily and raise prices. There's a degree of analysis required to make sure that we are raising prices in categories that are, in fact, inelastic. And so as we lay out our head, core, tail, head being the key price-sensitive categories, the tail being the least price-sensitive categories, we have to be very diligent to make sure that we just don't go across the entire business and just arbitrarily raise prices because then you're going to have a negative impact on top line. So as Dave mentioned, we are doing this in a very structured, very surgical way, and the good news is that the action we're taking is working. But we're analyzing it as we go to ensure that we're making the right decisions for the business. And that's all ongoing. And so we just thought it was prudent to adjust guidance based on the ongoing efforts with the expectation and the confidence that we're going to get this done, and we're going to be successful. And the good news is we think this will benefit us, not only for the balance of 2019. We're going to solve a problem that's been a legacy issue here for a while, and that issue will be behind us. And I'll let Bill talk about any other pricing concerns in the work that he and his team are doing to make sure that we continue to work with our suppliers to ensure that we are competitive from a cost perspective.

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William P. Boltz, Lowe's Companies, Inc. - EVP of Merchandising [15]

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Yes. I think just a couple of things to add. This is -- and when you start to take it on, when it's across a number of categories that's across, it's what I refer to as real pick and shovel work. And so it's a SKU-by-SKU review. You have to look at it at the assortment level as well so that we don't screw up the assortment philosophy of what a merchant's trying to do. So all of that is being done. And where we -- as both Dave and Marvin have mentioned, where we have been able to do some of that in the last few weeks, we have seen improvement happen.

In addition to that, as I've shared with you on the other calls, we're in the early stages of rolling out category management into the organization. So you want to be able to do this in conjunction with the category management philosophy, where you've got the intent of each of these product categories, so that the philosophy falls into, and that it can be built into the financial planning as you move into 2020. So we're rolling into that second phase of category management in the back half of the year where we start to apply it into each one of those product categories. You take this work, you've got to roll it in together so that we don't do something stupid. So that's what we're working on.

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [16]

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And Mike, I think it's worth me noting that we're looking at this short, medium to long term. So short term, we've improved visibility for the merchants on all pricing actions. We've eliminated the need to look at numerous systems, multiple reports to get basic pricing and cost information. We now have one team in place to manage cost and price. We now have the ability to prioritize which pricing actions we take to have the greatest impact on gross margin. Believe it or not, in Q1, we couldn't do that. We have a really simple philosophy that's pretty consistent in retail. And that is if you take a cost increase for any reason, you've got to offset that within the portfolio with actions to protect gross margin. All of these things sound basic, but these things didn't exist in Q1. So that's short term.

By Q4, Seemantini, our Chief Information Officer, is implementing a new price management system. It's going to be rolling out. It's cloud-based. It's agile. It's going to enhance the visibility for the entire merchant and finance team on pricing. It's going to be a single repository for pricing for Lowe's, something we currently don't have. And that's going to -- that is being developed as we speak. This would get us to parity.

Then the acquisition of Boomerang's retail analytics platform in 2020, we're going to integrate that to this new price management system. This is going to give us a best-in-class system on both price intelligence and price management. And this is another example that this is a multiyear transformation. So we've got short-term actions that we're taking right now. We've got actions later this year that's going to get us to parity with a pricing management system in 2020. We believe with the acquisition of Boomerang's retail analytics platform, we're going to have a best-in-class pricing system. And that's the cadence that we'll follow.

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Michael Lasser, UBS Investment Bank, Research Division - MD and Equity Research Analyst of Consumer Hardlines [17]

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That's helpful. Two more quick questions. Given that this surprised you, do you think, Marvin, that you might have underestimated some of the depths of the challenges that the business is under? And as a result, it's either going to take longer to achieve the longer-term margin expectations that you set for the longer-term margin expectations you might -- you're supposed to achieve? And then on the quarter, your sales performance has improved. How much of the incremental inventory that you added attributed to the better sales performance this quarter?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [18]

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So Mike, it's a fair question. We still feel good about the outlook we gave at the Analyst and Investor Conference this past December. There's a lot of work to do, and my team knows that one of my favorite comments is that all of the easy jobs are filled. So when we came here to take this on, we knew we're working for a great company with an outstanding balance sheet, but a comp that has underperformed this sector for a significant amount of time. If Q1 proved anything, it proved that this team can drive sales. And so we're pleased with our sales performance, and we're not going to decelerate our aggressive approach to driving sales. But when we think about what drives our sales and what we think allowed us to be successful in Q1, we think it's about getting in stock, about the investment and job lot quantities, about the improvements in customer service, about the space productivity that the MST team is helping to drive and the focus that Joe talked about in pro. We're in the early stages with pro. We understand that there are other things that we will do. We have a great platform in MSH that we are going to be talking about later this year. We have some initiatives we're working on with same-day job site delivery. We've got this wonderful unique pilot with FedEx on the same-day delivery bot that is going to change and revolutionize how you get product to pro customers. And so we have a long-term view, but we're just really pleased that the fundamentals that we've put in place for our business are paying dividends in Q1. And we think that's going to continue for the balance of the year. We simply have to get our arms around these issues.

And the last point I'll make is, are we going to have surprises? I'm sure we will. But when I look around the table at the men and women that are on this leadership team, we have people who have the experience, the talent and the expertise to solve these issues. And as devastating as the margin impact was in Q1 with these unanticipated, fully thought out cost increases, the team rallied, got our arms around it, and we're going to be able to resolve this as the year progresses.

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Operator [19]

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

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Zachary Robert Fadem, Wells Fargo Securities, LLC, Research Division - Senior Analyst [20]

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So online sales up 16%, a nice acceleration versus late 2018. Curious if you could speak to some of the drivers here. Anything new you're doing with respect to the website or online ads? Any category callouts? And then second part, as your online sales accelerate, could you speak to the margin impact? And any thoughts on mitigating the fulfillment drag there?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [21]

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So Zach, I'll take the first part, and I'll let Bill Boltz give you some specific information. As I mentioned in my prepared comments, I mean, 16% is improvement. And I am really pleased with the new leadership. We have an entirely new leadership team focused on our online business. We have a CIO who has a deep understanding of the online space. And so there's a great partnership happening right now, and there's a lot of what I call infrastructure and foundational work being done. One of the key things that we're in the middle of doing is taking this platform from a mainframe platform to cloud-based. And that's going to be significantly important to us because it's going to give us much more agility, and we can create a lot more dynamic responses to our customers. So I'll let Bill talk about what drove the business in Q1, but we think we're only at the early stages of what's going to be a tremendous business platform for us over the next couple of years.

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William P. Boltz, Lowe's Companies, Inc. - EVP of Merchandising [22]

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Yes. So a couple other comments to make in regards to online. I think I'm certainly pleased with the growth over Q4 of '18. But as we think about big changes that we're making, we're now putting an organization in place that's dedicated and focused on this part of the business. So with that, it means online merchants, online merchants tied into the product categories and merchandising departments within our core merchandising groups, so that we can pull the strategies through on Lowes.com. The team's also in the process of working through foundation stability that Marvin mentioned to make sure that our site operates the way we need it to operate. We're also working on enhanced content with all of our supplier partners, and we're ramping up the amount of SKUs and assortments that we carry on Lowes.com. So a lot of work going on there. In addition, the direct fulfillment center that we opened outside of Nashville a year ago, working with the supply chain team to be able to leverage that. And so we're in the early innings of that, but we're ramping up SKUs into that facility, which allows that pressure to come off of our stores, where they have been the fulfillment arm in the past, all of that making it easier for our customers to shop on Lowes.com. So we've got a lot of things that are in the works, a lot of things that have been done and a lot of things still to do to improve our performance there. And there's nothing but upside for Lowes.com.

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Zachary Robert Fadem, Wells Fargo Securities, LLC, Research Division - Senior Analyst [23]

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Got it. And then one for David. On the change in EBIT outlook, I just want to confirm that the 50, 60 basis point change or so, entirely at the gross margin line, and then whether you'd expect the impacts to be felt throughout the year or if this is more of a -- more concentrated in Q1, Q2 with improvement in the back half?

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [24]

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Yes. The vast majority of the impact will affect the gross margin line. I would expect us, our performance to get better later as we're -- as we said earlier, as we're taking action at the moment, that will bleed into our performance as we cycle through the year. So I think it'll be disproportionately affecting Q2 and -- versus 3 and 4.

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Zachary Robert Fadem, Wells Fargo Securities, LLC, Research Division - Senior Analyst [25]

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So do you expect gross -- or, I'm sorry, EBIT margins to be positive in the back half of the year?

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [26]

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Yes. We don't really guide to that level of specificity.

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Operator [27]

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Your next question comes from the line of Christopher Horvers with JPMorgan

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Christopher Michael Horvers, JP Morgan Chase & Co, Research Division - Senior Analyst [28]

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Can you talk a little bit about your business outside of seasonal? Obviously did a lot of work to front-load inventory, improved processes and drive in-stocks. Can you talk about the improvement in the rest of the business, particularly as we look into the back half of the year and the seasonal really fades? How are you thinking about the improvement that you're seeing in the back half? And then more broadly, tough compare in Q2, easier compare in back half, how are you thinking about cadence, especially in light of your comments that you should be able to accelerate demand because you didn't capture price inelasticity?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [29]

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Chris, I'll take the first part of this, and I'm going to let Joe McFarland talk a little bit about pros. Because as we look at Q2, when you separate the business from seasonal, we think the key to really driving the sales in Q1 was in the pro customer. We mentioned that pro significantly outperformed DIY for the quarter. And the thing that the pro customer does for us, it drives sales force space productivity because the pro shops the entire store. So when Bill talked about the power of MST and improvements in in-stock, that impacts the pro across the entire store. But I think the pro is really the key for us, was a key in Q1, will be the key for the balance of the year. And I'll let Joe just talk about some of the successes we saw and some of the things that we have planned moving forward.

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Joseph Michael McFarland, Lowe's Companies, Inc. - EVP of Stores [30]

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All right. Great. Thanks, Marvin. So as Marvin mentioned, we were very pleased with the acceleration of the pro business throughout the entire quarter. And as we mentioned, Phase 1 was really the retail fundamentals. And we really got our arms around the retail fundamentals in pro. I mentioned in my prepared remarks the supervisor, the dedicated staffing, the loaders, the job lot quantities. And so as you think about that we continue to see acceleration into Q2 in this pro business, and feeling that we now have a foundation in place, that we have the basics for the pro done as we accelerate that through the back half of the year with things like pro loyalty, things that will help us capture a much larger share of the pros' wallet, you'll see that come to life through brands, through advertising and through service in the store. So we remain very, very pleased with the progress.

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David M. Denton, Lowe's Companies, Inc. - Executive VP & CFO [31]

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I also think it's important to add that we had positive comps in 10 of 13 merchandising departments. And we saw growth beyond the seasonal categories, in categories like -- merchandising departments like millwork, like flooring, some of these areas that we've discussed in the past that have struggled, that we saw positive growth on. So I'm real pleased. Again, as I said in my comments, positive comps in paint, right, where we have struggled all year last year. And so that trajectory is on the right path. So we're excited about what's going on there.

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [32]

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We will take one more question, please.

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Operator [33]

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Your final question will come from the line of Brian Nagel with Oppenheimer

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [34]

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So I apologize if this first one's a bit repetitive. But Marvin, I just want to go back and look at the release data in your comments. The -- you had the 4.2% domestic comp, a nice improving trajectory through the quarter. You laid out, in the prepared comments, that, that, would have been markedly higher had it not been for weather. And then we had the issue on gross margin with the corrective actions you take. Am I hearing you correctly that those really are distinct events, meaning that the corrective actions that impacted gross margins did not contribute to the sales showing in the quarter?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [35]

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Brian, it did not. If anything, they hurt sales. Because our gross margin was negatively impacted, because we had cost increases that were taken in 2018 with no mitigating steps to offset gross margin. Our system visibility was so limited that merchants that took position in 2018 later in the year, and in some cases in 2019, had no visibility that these cost increases had even been accepted. And because of the first-in, first-out nature of our inventory and the layering impact of our inventory, we just start to recognize the cost until we turned the inventory in those items where we have, except the cost increases, started to flow through the stores and started to flow through transaction. So we had no visibility to it. And so it was a discrete kind of issue of cost increases, no steps to offset it. So as we look at it, we have, again, a pricing architecture of head, core, tail. And if we receive a cost increase and we accept it, what Bill will do is he'll work with the finance team supporting him, and they will take steps to find offsetting retail increases in nonprice-sensitive categories, i.e. tail items. Those items will then offset cost increases that you take, that you cannot affect retail in competitively priced items. We didn't do any of that. So in essence, we took cost increases, and we took no actions to raise retail. And because of that, we've decremented our gross margin, and we decremented our top line sales. So it is the worst of both situations. Now we're going back, as I mentioned and Dave have mentioned, and we're taking very specific actions to address those issues. And we're taking pricing actions, and we've been taking those actions for the past weeks. And where we've taken those actions, and those products are flowing through the stores and turning, we're seeing our gross margin improve on the items where we've taken the pricing action. We're still working through it. And so what we're trying to do is analyze the actions we're taking, making sure that we're not negatively impacting sales, and that we're solving the problem we're intended to solve. And that's taking time, and that's why we want to be prudent and update our guidance based on the analysis that's currently underway.

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [36]

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Got it. That's helpful. And then this is a follow-up, a quick follow-up I had. In the monthly comp cadence you gave us, you -- the domestic comp in the month of April was 8%. Recognizing it's early here in fiscal Q2, but any commentary how sales have tracked here into May or into Q2?

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [37]

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Well, what I will say is they're as expected. We have some big events, including this weekend, coming up. We feel like our in-stock position is as good as it's ever been. We feel like our staffing levels are as good as they have ever been, and we feel like that our stores are set and we are signed and we are marketing for success. As frustrated as we are by the gross margin performance and the poor decisions made and the limited system visibility on cost increases, we're correcting that. But we want to be crystal clear that we are aggressively going after sales. And we believe that the success that we have in Q1 will carry over into the balance of the year because it was driven by in-stock improvement, service improvement, improved space productivity and driving the pro sales. And we think we can maintain that in Q2 and for the balance of the year.

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Brian William Nagel, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [38]

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Let me -- if I could ask just one more, kind of a big open-ended question. But given the comments here about identifying this inventory flow issue -- I'm just going to say inventory flow issue, I mean, is that -- we're being surprised by it? Has that allowed you to now look elsewhere for other potential surprises if that makes sense? I mean, this issue popped up. Could your team now say, "Well, this issue popped up. Something else might pop up, but we're looking into that?"

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Marvin R. Ellison, Lowe's Companies, Inc. - President, CEO & Director [39]

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The short answer is yes. We have taken aggressive steps -- let me rephrase that, more aggressive steps to make sure we analyze, review and do systemic reviews of every single thing we can imagine so not to have another unexpected event like we experienced in Q1. And we're going to continue to be laser-focused on that. And the good news is we have people around the table with deep experience and deep expertise. The good news is we changed a lot of merchants, which was disrupted. We accept that, but we did it on purpose. Because we wanted to have the right merchant leaders sitting in position through spring of '19, so they could help us plot our strategy for fall, for spring of 2020 and beyond. And we have merchants with deep experience. We've got merchants with 30, 40 years of category experience now sitting in these vice president roles. And so they are helping us identify additional issues, but they have the skill set to solve them. And we now have the technical expertise in-house to get the right systemic solutions. And so, yes, we're doubling our efforts, making sure that we limit the number of surprises that will get us in the future.

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Operator [40]

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