Lowe's Companies' CEO Discusses Q4 2013 Results - Earnings Call Transcript

Lowe’s Companies, Inc. (LOW) Q4 2013 Earnings Conference Call February 26, 2014 9:00 AM ET

Executives

Robert Niblock - Chairman, President and Chief Executive Officer

Greg Bridgeford - Chief Customer Officer

Bob Hull - Chief Financial Officer

Rick Damron - Chief Operating Officer

Analysts

Greg Melich - ISI Group

Laura Champine - Canaccord

Michael Lasser - UBS

Brian Nagel - Oppenheimer

Aram Rubinson - Wolfe

Seth Basham - Wedbush

Keith Hughes - SunTrust

Kate McShane - Citi Research

Mike Baker - Deutsche Bank

Scot Ciccarelli - RBC Capital Markets

Peter Benedict - Robert Baird

Operator

Good morning, everyone and welcome to Lowe’s Companies’ Fourth Quarter 2013 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 through the slide, these slides are meant to facilitate your review of the company’s results and to be used as a reference document following the call.

During this call, management will be using certain non-GAAP financial measures. The supplemental reference slides include information about these measures and a reconciliation to the most directly comparable GAAP financial measures. Statements made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Management’s expectations and opinions reflected in those statements are subject to risks and the company can give no assurance that they will prove to be correct. Those risks are described in the company’s earnings release and in its filings with the Securities and Exchange Commission.

Hosting today’s conference will be Mr. Robert Niblock, Chairman, President and Chief Executive Officer; Mr. Greg Bridgeford, Chief Customer Officer; and Mr. Bob Hull, Chief Financial Officer.

I would now turn the program over to Mr. Niblock for opening remarks. Please go ahead, sir.

Robert Niblock - Chairman, President and Chief Executive Officer

Good morning and thank you for your interest in Lowe’s. We delivered comparable sales growth of 3.9% for the quarter with positive comps in 10 of our 12 product categories and a continued balance of ticket and transaction growth. And our ProServices business continued to perform well. We achieved this growth despite a holiday season, where the retail sector experienced softer sales than anticipated. Through continued use of our enhanced sales and operations planning process, we balanced softer sales of seasonal gift and holiday decorations with solid performance in core categories for interior refresh projects.

We continued to see strength in recovery markets with particular strength in California, Arizona and Florida, where the housing recovery is well underway. In fact, even with pressure exerted by extreme weather late in the quarter in the northern and central areas of the country, we recorded positive comps in all regions except for the region most directly impacted by Superstorm Sandy recovery activity last year. I am also pleased with our performance in Canada, where the team has delivered double-digit comps in local currency for the third consecutive quarter.

Gross margin expanded 40 basis points in the quarter driven by a number of factors that Bob will discuss. And we delivered earnings per share of $0.29 for the quarter, which included approximately $0.02 of charges related to long-lived asset impairments. For the year, we delivered comparable sales growth of 4.8%, our strongest annual comp since 2005. Earnings per share were $2.14, a 26.6% increase over fiscal 2012. Delivering on our commitment to return excess cash to shareholders in the quarter, we repurchased $958 million of stock and paid $189 million in dividends. For the year, we repurchased $3.7 billion of stock and repaid $733 million in dividends.

Looking at the landscape for 2014, economic forecast suggest moderately accelerating growth. Stronger job and income growth should create a more favorable environment for consumer spending which coupled with the lagged benefit of the housing recovery should generate continued growth in the home improvement industry. While credit conditions remain tight relative to the housing boom years, conditions are improving and household finances continue to strengthen, which should also contribute to stronger growth in 2014. Also supporting increased home improvement market growth is positive progression in consumers’ views around personal finances and home values that we saw in our fourth quarter consumer sentiment survey.

Homeowners continue to believe the value of their home is increasing and report that they are less likely to decrease spending. With consumers more willing to invest in their homes, the job and the income growth forecasted for 2014 should provide the wherewithal for continued home improvement spending. In 2014, we will continue to capitalize on opportunities within an improving economy. We will build on the momentum established in 2013 as we further optimize our business model. We have substantially completed our initiatives to enhance retail relevance, including value improvement, product differentiation and our store labor investment and we will operationalize and refine these initiatives in 2014.

Our top line performance improved this year as a result of our focus on cross-functional collaboration and consistent execution along with our strategic initiatives which allowed us to more fully capitalize on market demand. Now, we are focused on improving our profitability even while investing in key capabilities to drive sales growth.

Over the longer term, we remain committed to satisfying customers’ needs whenever and wherever they choose to engage with us into differentiating with better customer experiences than any other home improvement provider. Determined to be a customer-centered omni-channel retailer, we have been investing in infrastructure, both systems and processes. Our focus on transforming our current multi-channel offering in-store, online including mobile technology, in-home and by phone to an omni-channel experience with our brand. Through enhanced customer service tools, we expect to improve our associates’ ability to sell seamlessly across channels, introduce new project management tools and to expand fulfillment capabilities beyond our bottom line, pickup in store are partial fulfillment of online orders both of which we do today. And we will cultivate personal and simple connections with customers over and above what was accomplished to-date with MyLowe’s. These new capabilities are projected to be in market in 2015.

We will differentiate Lowe’s by delivering better customer experiences. In order to help customers visualize our home improvement projects, we will offer a cohesive group of products that provide relevant occasion-based solutions and will present them in an inspiring manner. Greg will discuss further how we will begin building customer experience design capabilities in 2014.

The commitments we have made to improve for customers and shareholders require unrelenting determination. Completing the transformation we have undertaken is not like flipping a switch, it’s more gradual and deliberate like turning up the dial as we add new capabilities. I want to thank our employees for their dedication and hard work toward this long-term commitment. The momentum created by retail relevance initiatives are strengthening execution and our keen focus on productivity and flow-through give us confidence in our business outlook for 2014. Bob will share those details in a few minutes. Thanks again for your interest.

And with that, let me turn the call over to Greg.

Greg Bridgeford - Chief Customer Officer

Thanks, Robert and good morning everyone. We continue to drive balanced performance in the quarter with strong execution and further momentum from our initiatives. We offset a soft holiday gift giving environment by assisting customers in preparing their home for guests and cleaning and organizing after the holidays. For instance, many customers were looking to replace their older appliances. Using our enhanced sales and operations planning process, we have tightly coordinated advertising, promotions and inventory. As a result, we drew customers to Lowe’s and we met their needs through a broad assortment of innovative appliances, which combined with our service advantages of next day delivery and haul away and in-house facilitation of service calls provides the best in customer service and simplicity.

We also drove strong sales of fashion fixtures both by making incandescent bulbs available to customers working to beat the government deadline and by providing compelling new fashion plumbing products and sets for customers who are refreshing their bathrooms. And we know that winter weather can be unpredictable. So we are ready to respond quickly to the demand for items needed to cope with the January storms across many markets in the northern and central areas of the country. Customers needed snow blowers, space heaters, heating fuels, snow shovels and ice melt as well as pipe fittings to replace those that burst from the extreme cold. Working with our vendor partners, we drove strong performance in these products using our distribution network to quickly and efficiently move them to where they were needed most.

Our performance in the quarter is also a testament to the improved line designs and inventory depth resulting from value improvement. I am pleased to share that at the end of the quarter, we had completely finished the first round of value improvement line reviews and substantially all of the associated resets. We will continue to conduct line reviews in the normal course of business, but the annual volume of resets will be lower going forward. Examples of resets completed in the fourth quarter include core products like pliers and wrenches, décor products such as bathroom vanities and pedestal sinks, and seasonal products such as house and patio plants.

Value improvement is now fully operationalized. This means that the improved line review and product reset processes are woven into our everyday business and are being used at an appropriate cadence for each of our nearly 400 product lines. Even so we expect the initial round of value improvement resets to further contribute to our profitability in 2014 as we obtain a full year of benefits from resets completed over the course of 2013. We are now better positioned to meet customers’ product needs and drive better inventory productivity.

We are also pleased that we modestly leveraged payroll expense in the quarter. We have made the store labor investment more productive by refining our allocation of these hours by store and by selling department. In the quarter we increased sales per hour by approximately 2%. As we lap the introduction of the store labor investment in the first quarter, we expect to obtain even greater leverage which will contribute to greater 2014 operating profit. The store labor investment and value improvement are two of our initiatives designed to enhance retail relevance. Our third is product differentiation, which is intended to drive excitement in our stores through better display techniques including our revised end cap strategy and revamped promotional spaces. Product differentiation has been reset in 1,400 stores to-date and will be rolled to the remaining U.S. home improvement stores in the first half of 2014.

In addition to operationalizing our most recent initiatives, in 2014 we will focus on driving more of our revenue growth to the bottom line through expense control and disciplined execution of our plans. We will also focus on three priorities to drive further top line growth. The first two aimed to capitalize on opportunities within an improving economy. First, we will use our enhanced selling and operations planning process to address micro-seasons by market. And second, we will improve our product and service offering for the pro customer. Our third priority will be to build customer experience design capabilities.

Through our sales and operations planning process, we have addressed an opportunity to improve seasonal planning including the cadence of product introductions, promotions and staffing. While we have always planned and executed these seasons in our stores, previous planning was completed function by function, and then reconciled to minimize conflicts, now the process starts earlier and is anchored on the customer mindset for the season. The process more thoroughly considers detailed input from all functions to determine resource allocation and it enables Lowe’s to provide a consistent messaging experience across all selling channels; stores, Lowes.com, contact centers and in-home selling.

We also have an opportunity to better capitalize on pro market, which is growing faster than the consumer market. We will do this by enhancing our product and service offering with this important customer. While pros shop across the store, the penetration of sales to pro customers is highest within the traditional building and maintenance categories, including lumber and building materials, millwork, rough plumbing, electrical and tools and hardware. So we grouped those categories into the leadership of a general merchandise manager who is focused on ensuring we have the types of products and brands that pros demand.

Of course, winning the pros business also requires great service to make doing business with us as quick and convenient as possible. So we continue to ensure we reach out to pros through multiple channels whether in-store where we have dedicated specialists to answer questions and dedicated loaders to help and get back to the job quickly or the pros’ place of business where our account executives help regional maintenance, repair and operations customers order and replenish products across multiple stores or through the national account representatives who assist the customers doing business with Lowe’s across the country. In the second quarter, we will re-launch LowesForPros.com, which will provide a dedicated platform for pro customers to purchase online from Lowe’s. LowesForPros will also allow pros to access contract pricing, develop requisition list and view purchase history, and LowesForPros will be enabled for convenient mobile access.

We also have an opportunity to more broadly enhance the customer experience. Customers already give us credit for a better customer experience and we are strengthening that advantage. We are developing a process to coordinate the elements of great occasion based customer experiences. To clarify, I would like to define occasion. Customers don’t simply shop for products, they shop to repair something, to replace something, to refresh a room or complete a major remodel. These are occasions and we have the opportunity to build experience around these occasions that will inspire customer diversion, differentiate Lowe’s in the marketplace and ultimately lead to superior business results.

To do so, our customer experience design team is getting under the hood with customers, understanding how they think about home improvement projects, from planning, shopping and buying, to using and enjoying and based on these insights, designing an ideal experience with all channels in mind. Now, that experience must meet three critical criteria. First, it must be desirable to a target customer. Second, it must be feasible, in other words, must fit within our organization’s competencies. And third, it must be viable, something that we can deliver in a profitable and sustainable way.

In 2014, we will begin building these customer experience design capabilities. We also – we will also introduce a number of changes to our stores and website that will become a stage for future experiences. We will invest in experiences that we expect to drive market share growth and solid return for investors. We expect 2014 reset expenses to be approximately flat to 2013 as declining expenses associated with line reviews are offset by increased customer experience design resets.

As Robert said, we continued to turn up the dial of our transformation. Even as we focus on optimizing our business model, driving profitability and capitalizing our market opportunities within an improving economy, we are investing in customer experience and omni channel capabilities to drive future sales growth.

Thank you for your interest in Lowe’s, and I will now turn the call over to Bob.

Bob Hull - Chief Financial Officer

Thanks Greg and good morning everyone. Sales for the fourth quarter were $11.7 billion, which represents a 5.6% increase over last year’s fourth quarter, but was approximately $100 million below our expectations as the result of extreme January weather Robert mentioned. Total transaction count increased by 4.4% and total average ticket increased 1.1% to $63.08.

As discussed last quarter, the Orchard Supply smaller format neighborhood hardware stores are located in densely populated markets and offer a product selection focused on paint, repair and backyard categories. As a result, Orchard stores have more transactions per square foot, but fewer per store and a lower average ticket than a traditional Lowe’s store. So while Orchard aided total company sales by approximately 100 basis points and added roughly 260 basis points to our transaction growth, it negatively impacted average ticket by almost 150 basis points. The Orchard stores are considered non-comp, but will be included in our comp sales calculation after the anniversary of the acquisition in the third quarter of 2014.

Comp sales were 3.9% for the quarter. As you heard from Greg, further momentum from our initiatives and improving execution drove balanced performance in the quarter. Comp average ticket increased 2.4% and comp transactions increased 1.4%. Looking at monthly trends, comps were 3.3% in November, 6.3% in December and 1.4% in January. For the year, total sales were $53.4 billion, an increase of 5.7%, driven by a comp sales increase of 4.8%, the Orchard acquisition and new stores. For 2013, comp average ticket increased 3.2% and comp transactions increased 1.6%.

Gross margin for the quarter was 34.67% of sales, an increase of 40 basis points over last year’s fourth quarter. Value improvement helped gross margin by approximately 40 basis points in the quarter. Also sales mix and lower inventory shrink aided gross margin, but these items were essentially offset by markdowns necessary to clear seasonal product and our proprietary credit value proposition. For the year gross margin of 34.59% represents an increase of 29 basis points over fiscal 2012.

SG&A for Q4 was 26.12% of sales, which de-leveraged 69 basis points. The SG&A de-leverage was driven by a variety of factors. In the quarter we incurred $32 million in expense for asset impairments. This compares to $8 million for asset impairments and discontinued projects last year, resulting in 20 basis points of expense de-leverage for the quarter. Risk insurance de-leveraged approximately 10 basis points due to favorable adjustments experienced last year that didn’t repeat this year.

Property tax expense de-leveraged approximately 10 basis points due to an increase in property valuations and cycling of favorable adjustment from last year. The strengthening U.S. dollar cause losses in market values of forward cash position and forward contracts causing almost 10 basis points of de-leverage. Also building and site repair reset and proprietary credit expenses each de-leveraged about 5 basis points in the quarter. For the year, SG&A was 24.08% of sales and leveraged 16 basis points versus 2012. Depreciation expense was $370 million for the quarter, which was 3.17% of sales and leveraged 56 basis points. The leverage was driven by the increase in sales as well as assets becoming fully depreciated.

Earnings before interest and taxes for the quarter were $627 million, which represents a 27 basis point increase to 5.38%. EBIT was about $15 million below our expectations driven by lower sales and the impairment expense. We are pleased with our efforts to manage expenses to mitigate these two items. For the year, EBIT of 7.77% represents an increase of 72 basis points over 2012. Interest expense at a $128 million for the quarter de-leveraged 11 basis points as a percentage of sales. The increase in interest was attributable to the $1.4 billion increase in total debt relative to last year.

Pre-tax earnings for the quarter were 4.28% of sales. The effective tax rate for Q4 was 38.7% which was consistent with our expectations. The higher rate this quarter relative to the 36.7% last year was driven by expiring tax provisions, which impacted year-over-year earnings growth by approximately $10 million. For the year, the effective tax rate was 37.8% compared to 37.6% for 2012. Q4 net earnings of $306 million increased 6.3% versus last year. Earnings per share of $0.29 for the quarter were up 11.5% to last year. The asset impairment expense resulted in an EPS drag of approximately $0.02 for the quarter. For fiscal 2013, earnings per share of $2.14 were up 26.6% versus 2012.

Now, to a few items on the balance sheet starting with assets. Cash and cash equivalents at the end of the quarter was $391 million. Inventory at $9.1 billion was up $527 million or 6% over last year. Approximately, 30% of the increase was driven by Orchard Supply and the remainder to support demand. Inventory turnover is calculated by taking a trailing four quarters’ cost of sales divided by average inventory for the last five quarters was 3.74 times, which was flat to last year. Asset turnover is determined using the trailing four quarter sales divided by average assets for the last five quarters increased 12 basis points to 1.59 times.

Moving on to the liabilities section of the balance sheet. We ended the quarter with $386 million in commercial paper outstanding. Accounts payable at $5 billion was up nearly 8% to last year. The increase in accounts payable relates to the timing of purchases. At the end of the quarter, lease adjusted debt to EBITDAR was 2.23 times. Return on invested capital measured using a trailing four quarters earnings plus tax-adjusted interest divided by average debt and equity for the last five quarters increased 217 basis points for the quarter to 11.5%.

Now, looking at the statement of cash flows. For the year, cash flows from operations were $4.1 billion. Cash used for capital expenditures was $940 million resulting in free cash flow of almost $3.2 billion, which was a 24% increase over 2012. During the quarter, we repurchased 19.9 million shares for $958 million through the open market. Also in the quarter, we received approximately 1.6 million shares as part of the final settlement associated with the accelerated share repurchase program executed in Q3. For the year, we repurchased almost 87 million shares for a total of $3.7 billion. I am pleased to announce that our board has approved an incremental $5 billion share repurchase authorization. With $1.3 billion remaining on the prior authorization, we had total share repurchase authorization of $6.3 billion at year end with no expiration date.

Looking ahead, I would like to address several of the items detailed in Lowe’s business outlook. As Robert noted, the economic forecast suggests modestly accelerating growth in home improvement industry in 2014. We are optimistic about our improving execution, but with a recent slowdown in both housing activity and jobs growth we have taken a cautious approach to our 2014 outlook.

For the year, we expect total sales increase of approximately 5% driven by a comp sales increase of 4% and the opening of approximately 15 big-box stores in 5 Orchard Supply locations. We expect to have our highest comp in Q1. This is an important quarter for home improvement and the easiest compared to last year. In addition, we expect the first half comp to be modestly higher than the second half of the year. We are anticipating an EBIT increase of approximately 65 basis points. As we have discussed in the past, 20 basis points of EBIT expansion per point of comp above 1% is a good rule of thumb for the year. However, there might be some choppiness quarter-to-quarter.

Let me offer two items that will put some pressure on the flow-through for the first quarter. In Q1 last year, we had a negative comp and reduced bonus accruals. This year we have planned to accrue the target levels resulting in de-leverage of 20 basis points in Q1 while leveraging roughly 20 basis points for the year. Also we will experience risk insurance de-leverage in the first quarter as we cycle favorable adjustments from Q1 last year. This item is expected to de-leverage 20 basis points in the first quarter, but only 10 basis points for the year. We expect EBIT improvement will come from both gross margin expansion and SG&A leverage. Our initial focus during our transformation was on market growth. While market growth is still a priority, we are also focused on flow-through. The effective tax rate is expected to be 38.1%. The higher rate is driven by the expiration of tax provisions at the end of calendar 2013. The higher rate impacts earnings per share by almost $0.01 per share. For the year, we expect earnings per share of approximately $2.60, which represents an increase of 21.5% over 2013.

Our 2014 outlook includes approximately $35 million of incremental expenses associated with the Affordable Care Act or about $0.02 per share. We are forecasting cash flows from operations to be approximately $4.1 billion. Our capital plans for 2014 is approximately $1.2 billion. This results in estimated free cash flow of $2.9 billion for 2014. We expect to issue incremental debt during the year as we manage through the 2.25 times lease adjusted debt to EBITDA target. Our guidance assumes approximately $3.4 billion in share repurchases for 2014 spread evenly across the four quarters.

Regina, we are now ready for questions.

Earnings Call Part 2:

• Q&A with Lowe's Companies, Inc. CEO