Good morning, everyone, and welcome to Lowe's Companies third quarter 2018 earnings conference call. This call is being recorded. Please note, if you pressed star one to enter the question queue prior to the start of today's call, your signal did not register. You will need to press star one again to enter the queue. Also, supplemental reference slides are available on Lowe's Investor Relations website within the investor packet. While management will not be speaking directly to the slides, these slides are meant to facilitate your review of the company's results and to be used as a reference document following the call. During this call, management will be using certain Non-GAAP financial measures. The supplemental reference slides include information about these measures and a reconciliation to the most directly comparable GAAP financial measures.
Statements made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Management's expectations and opinions reflected in those statements are subject to risks, 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.
Thank you, Regina. Good morning, everyone. As reflected in our earnings release earlier today, the strategic reassessment of our business continued in the third quarter. Our top priority this quarter was taking the necessary steps to build a sustainable foundation to position Lowe's for long-term success by exiting underperforming stores or non-core businesses. This will allow us to intensify our focus on our core retail business. As part of the strategic reassessment, we made the decision to close 20 U.S. stores and 27 stores in Canada, as well as four other Canadian locations. We also intend to exit our retail operations in Mexico and our Alacrity Renovation Services and Iris Smart Home businesses. These were difficult decisions to make, we believe we can deliver the greatest return to our shareholders by focusing our attention on running outstanding retail businesses in U.S. and Canada.
These actions send a clear message that we'll no longer pursue ventures that dilute our return on capital. Instead, we're committed to a more effective capital allocation process that will deliver better returns to our shareholders. I'm pleased to announce that we have substantially completed our strategic reassessment of the business, now we can shift our attention to improving execution in our retail stores and online. Of course, we'll continue to evaluate all elements of our portfolio annually. Now let me comment on our performance in the third quarter. We delivered comparable sales growth of 1.5%, driven by a 2.3% increase in average ticket, partially offset by a 1% decline in transactions. Our U.S. home improvement comp grew at 2% with positive comps in 11 of 14 geographic regions.
As expected, the Tampa and Houston markets had the weakest comparable sales in the quarter due to tough prior year comparisons from Hurricane Harvey and Hurricane Irma. We also posted 12% comp growth on lowes.com. Diluted earnings per share were $0.78 for the quarter and adjusted diluted earnings per share were $1.04, a decrease of 1% for the same period a year ago. Our third quarter results reflect many of the themes we discussed on our second quarter call. First, while we drove strong traffic to our stores and website, out-of-stocks continued to pressure sales. Second, our inefficient reset process continued to create disruption in our stores and contributed to out-of-stocks. In fact, all of our categories with negative comps, millwork, paint, fashion fixtures, and flooring, were pressured by poorly executed resets.
Third, our store processes are too complex, our labor management system is primitive, and our associates are burdened with too many tasks. These distractions are preventing our associates from spending adequate time with the customer to provide assistance. Fourth, our project specialist and install sales business is too complicated, which prevents us from delivering an outstanding customer experience and it pressures our sales. The good news is I'm pleased with the strategic initiatives the leadership team designed in Q3 to address these chronic issues. You'll hear more about these plans later in the call. As I said earlier, our priority in the third quarter was building the sustainable foundation for long-term success. Part of the foundation for long-term success was identifying a world-class Chief Information Officer. Earlier this month, we're pleased to name Seemantini Godbole as our new Chief Information Officer.
Seemantini is an accomplished retail executive with more than 25 years of global technology expertise and a proven track record for transforming IT and omni-channel systems. This is the final addition to our executive leadership team, and I'm confident in her ability to help us modernize our IT and omni-channel systems. Also during the third quarter, our new leadership team assessed their functional areas, upgraded talent, conducted deeper dives in their business areas, and the team was committed to identifying the root causes of our sales per square foot challenges. Merchandising reset issues are chronic out-of-stock and our low job lot quantity issues. Rather than implementing quick fixes to address these chronic and longstanding issues in the third quarter, we developed plans to drive sustainable improvement, and this is reflective of our commitment of building a foundation of sustainable long-term success.
In a moment, Bill Boltz, our Executive Vice President, Merchandising, and Joe McFarland, our Executive Vice President, Stores, will walk you through a detailed review of the third quarter results and outline improvements they're making in merchandising and store operations, as well as their plans for the fourth quarter. I'm also pleased to welcome Dave Denton to the call. As we previously announced in August, Dave has been appointed our Chief Financial Officer. While today is his first official day with the company, he spent the past several weeks meeting with our executive leadership team and will share his views on the business as well. Now turning to the macroeconomic environment.
Although interest rates have ticked up and housing turnover has been pressured, the home improvement backdrop remains strong, driven by robust real residential investment, home price appreciation, which continues to encourage homeowners to engage in discretionary projects. The average age of the homes in the U.S. is 40 years, which creates an attractive opportunity for our project categories that support maintenance and repair. Consumer confidence continues to hover at high levels as consumers remain upbeat about their employment and income prospects. Suggestions that we will continue to see solid gains in consumer spending, supported by strong real disposable personal income growth. Looking ahead, our future's bright. We operate in a fragmented $900 billion marketplace, and we have a unique opportunity to fix some longstanding chronic issues that will improve our performance and increase our market share.
As we look at our Q3 results, specifically our top line underperformance both in stores and online, we see the issue as poor execution, not a macro concern. As I mentioned earlier, we're not chasing short-term fixes, but we have every expectation that our actions and initiatives will begin to drive improvements in our business as we enter 2019. I look forward to sharing more details on our long-term strategic plans at our Analyst and Investor Conference on December 12th. Now before I close, I'd like to thank our associates for their hard work and dedication to serving customers. Our systems and our processes don't make it easy for our associates. Nevertheless, I'm incredibly proud of the way they support customers, each other, and the communities in which they live and work. This is evident in their response to Hurricane Florence and Hurricane Michael this quarter.
We've already hosted 27 hurricane relief events and served 15,000 hot meals. We've delivered 18,000 disaster relief buckets for impacted communities. This afternoon, our associates will serve 50,000 people Thanksgiving meals in hurricane-impacted areas of North Carolina and Florida. I'd also like to send our thoughts and prayers to all the individuals in the communities being impacted by the California wildfires. We're using one of our closed Orchard Supply Hardware locations for emergency relief and to warehouse donated supplies from the community. This is the most devastating wildfire in California history, and we will do all we can to support our associates and the communities impacted by this horrific event. Now with that, I'll turn the call over to Bill Boltz.
Thanks, Marvin, and good morning, everyone. Today marks my 99th day with Lowe's, and I'm pleased to be here to discuss the performance of the merchandising team. As Marvin shared with you, we posted comparable sales growth of 2% in U.S. home improvement this quarter. The favorable macro environment, combined with great values and events, drove traffic to our stores and website. The continued challenges with out of stocks, poor reset execution, and assortment issues in certain categories put pressure on our ability to turn those visits into transactions. Let me take a moment to discuss some of the positives from the third quarter. Seven out of 11 merchandising departments had positive comps in the quarter. Seasonal and outdoor living, appliances, lawn and garden, kitchens, and rough plumbing and electrical all delivered comps above the company average.
Seasonal and outdoor living led the way with high single-digit comps, driven by double-digit comps in grills and lawnmowers. Along with the increased demand driven by the inventory rationalization activity, in addition, we also delivered on a response for hurricane-related products such as generators, air conditioners, and dehumidifiers. Our lawn and garden comps were the result of capitalizing on the extended growing season, along with our fall preparation activity in our grass seed, fall fertilizer, live goods, and watering programs. For the ninth quarter in a row, we drove above-average comps in appliances as we continued to leverage our omni-channel offering through our leading brands, our breadth of assortment, and strong Labor Day and Columbus Day events. Our kitchen department also posted above-average comps with strength in organization and shelving, as well as cabinets and countertops.
We also had solid performance in our core pro product groups within rough plumbing and electrical. We continue to be excited about the effectiveness of our new destination brands attracting pro customers, as was evidenced by the double-digit comps in SharkBite plumbing fittings and our strong growth in water heaters, driven by the professional brand of A. O. Smith. Also during the quarter, we completed the rollout of two key programs into our stores with Zoeller Pumps and MAPEI tile setting material. We also launched new exclusive Pro cordless power tools from both Bosch and Metabo HPT, that brings the power of a corded tool to the job site through the ease and convenience of cordless. We continue to see robust consumer demand bolstered by a strong home improvement sector. As Marvin noted, during the third quarter, we took steps to begin to strengthen our merchandising focus on our retail basics.
We've added industry experts to the team as part of building out a world-class merchandising organization. In addition, as many of you know, in the third quarter, we also undertook an aggressive inventory clearance process that was focused on eliminating slow-moving or underperforming SKUs, and ultimately reducing the clutter in our stores. With that process complete, we have now begun reinvesting those dollars into improving in-stock on our best-selling SKUs and focusing on job lot quantities for the pro customer. Although the inventory clearance activity and the subsequent reinvestment will allow for strategic benefits in the future, the discounted sales cannibalized other merchandising categories during the quarter. Within merchandising, we are streamlining our decision-making processes.
We are investing in faster-moving SKUs, and we are shifting the mindset from managing to an inventory dollar amount to managing to an inventory turnover goal, which, for example, will allow us to have sufficient inventory on hand before the season breaks and have the stores set and ready for our customer. Now let me discuss some of the opportunities from the third quarter. Our underperforming categories were largely impacted by out-of-stocks stemming from poor reset execution, all of which had recovery dates that were pushed back, and therefore the planned improvements were not realized in the quarter. Millwork was pressured by supply and reset challenges in categories such as window blinds, resulting from a difficult product transition. Out of stocks and limited job lot inventory in core product categories, including both interior and entry doors, also exerted pressure on the comp.
We expect to see improvements in these areas in the early part of 2019. Our paint business was impacted by brand transitions along with supply disruption as we transitioned into our exclusive partnership with The Sherwin-Williams Company. Going forward, we're working with our supplier to improve our inventory position, and we expect to see improvement in this area by year-end. Our fashion fixtures department was negatively impacted by reset challenges in light bulbs and commercial lighting, where supply availability and a shortage of third-party labor to perform the resets led to out-of-stocks and reset delays. We expect to make continued progress in our reset completion and in-stock improvements throughout the fourth quarter.
The underperformance in our flooring business continued and was driven by reset disruption in hard surface and an assortment that is still overly focused on soft flooring as we continue to see consumers shift to the ease and innovations that are available in vinyl plank flooring. Going forward, our new assortments will better reflect this trend with the expansion of our exclusive SMARTCORE vinyl plank products. Our updates to these areas, which are in the early stages, will introduce new lower price points in laminate that will provide great values to both the pro and DIY customer. These updates will also expand the off-shelf space and will introduce new looks and trends for tile, laminate, and vinyl planks that will be assorted to the local market. Given the complexity of these activities, we expect to have solutions implemented in the latter half of 2019.
Although we were not pleased with our execution or results in the third quarter, as Marvin mentioned, we have identified the root causes of the issues that negatively impacted our sales. We are focused on changing our results by enhancing our processes to address these issues, and we anticipate that we will see the improved execution in 2019. Let me transition to the fourth quarter. We are excited about our continued rollout of Craftsman, including individual mechanics tools, hand tools, and power tools. Throughout the fourth quarter, we will showcase Craftsman on multiple end caps, highlighting exclusive products and offers, including three great values that are featured at $99. We are proud to be the exclusive destination in the home center channel for this iconic brand, offering some of the best hand tools, storage, and outdoor power equipment products in the industry.
We are also excited about our plans for an integrated omni-channel holiday experience that will be driven by strong Black Friday, Cyber Monday, and other key holiday events. We will continue to highlight our best-in-class appliances offering and showcase strong values focused around tools, holiday lighting, trees, and decor, along with other great gift ideas from across the store. As part of our refocus on merchandising basics, we have five key priorities. One, we are simplifying our merchandising organization, and we are continuing to recruit talented, experienced leaders to enable faster decision-making and to ensure that we are optimizing our assortments across all channels. Two, we are implementing a localized assortment strategy with the development, rollout, and support of a field-based merchandising team. Three, we are taking steps to rebuild our reset process by reducing our reliance on third-party labor.
With that, we are redesigning our internal reset process with the implementation and rollout of our new merchandising service team or what we refer to as MST. We are changing our endcap and off-shelf strategy to showcase great values and innovation that drive traffic and that ultimately improve the overall sales productivity of this valuable real estate in our stores. We will continue to strengthen our merchandising presentations by adding key brands to our assortments and by investing in both job lot and presentation quantities within our best-selling SKUs. All of this is designed to drastically improve the experience for our pro customers. All five of these initiatives were launched at the end of the third quarter. We will be laser-focused on the rollout plans and execution as we move into 2019.
I look forward to discussing these five priorities in more detail at our December 12th Analyst and Investor Conference. We are excited about the opportunity ahead of us, and we are working very hard to position Lowe's for the future and to capitalize on the strong demand in a healthy sector. Our changes will take time, but we have a detailed plan in place to allow us to make steady progress with near and long-term wins. Thank you. Now I will turn the call over to Joe.
Thanks, Bill. Good morning, everyone. Like Bill, I too am celebrating my 99th day with Lowe's. I am very excited to share with you the steps we are taking to improve store operations. When I joined the company, it struck me that some of the basic and foundational elements of operations were not in place. As an example, there were no engineered standards for in-store processes like unloading a truck, flowing product from receiving to the sales floor, or stocking a shelf to drive in-stocks. Labor scheduling systems were antiquated and ineffective, leading to payroll inefficiency and detracting from customer service. Other than cost of goods sold, payroll is the largest expense for the company. We had limited ineffective tools to track, allocate, or monitor coverage. In addition to payroll inefficiency, stores were inundated with communications and reports with no prioritization.
This lack of payroll efficiency, combined with nonexistent communication standards, led to process breakdowns like excessive out-of-stocks and a poor customer experience. Although these process challenges hindered our execution in the third quarter, I have encountered these types of issues before and have put solutions in place to solve them. Therefore, in the third quarter, we established an operations team with home improvement experts, took initial steps to simplify our focus, and developed processes and procedures to address all identified issues. As part of simplifying operations, we are focusing the teams on key priorities and metrics while removing distractions and non-value-added tasks. To improve customer service, we have recently eliminated sales floor tasking activities during the busiest hours of the day so that our associates can focus solely on selling and providing excellent service.
This process eliminates competing demands and provides a clear, concise, and consistent approach to deliver a repeatable and reliable customer experience across all stores. Earlier this month, we also significantly reduced the volume of communications and reports going to our stores. Previously, corporate and field associates communicated directly with the stores, bypassing the formal gatekeeping process and leading to information overload, conflicting messages, and inconsistent execution. To focus our teams on the most essential initiatives and allow them to spend more time with customers, we funneled all store communications through a single portal, established clear weekly priorities, and held the stores accountable for executing against these priorities. To drive efficiency, we've also streamlined the reams of reports and metrics sent to our stores and instead focused the teams on analyzing and improving their customer service scores.
To address the overly complex project specialist and installed sales business that Marvin mentioned, we recruited an experienced industry leader to the team in the third quarter. Through his leadership, we are taking steps to simplify and redesign how we engage customers and grow sales in this very important business. I look forward to sharing more details with you at our December 12th Analyst and Investor Meeting. In addition to simplifying our focus in stores, we developed a comprehensive in-stock process, including standardized procedures for efficiently moving product from receiving to the sales floor, and rolled it out to U.S. stores in November. We expect that we'll begin to see measurable improvement in our in-stocks as we head into 2019. As we work to improve our customer engagement, we continue to invest in our military appreciation program.
During the World Series and over Veterans Day weekend, we ran a television spot featuring our veteran associates, thanking all veterans for their service while building awareness of our 10% off discount for active duty and retired military. As a Marine veteran who served in both the Gulf War and Desert Storm, I'm proud of the fact that through our military discount, we'll provide over $1 billion in savings for our veterans this year. This is unprecedented in retail, and I'm proud to work for a company that stands with our veterans. To recap, as part of our store operations focus on retail fundamentals, we have five key priorities. One, we have developed and are rolling out engineered standards for all in-store operational activities. Two, we are taking steps to simplify communications and reporting sent to our stores.
Three, we are rolling out a consistent and comprehensive strategy to improve our inventory in-stock execution. Four, we are developing a new payroll allocation system to deliver a better customer experience while driving payroll efficiencies. Finally, we are establishing clear priorities to ensure that customer service is top of mind for our associates in the stores. This includes giving our district managers and store managers the autonomy to adjust assortments in their stores to meet the local demands of their customers. We are a big believer in the power of entrepreneurial spirit in the home improvement retail. We know there is still more work ahead to fully capitalize on the healthy demand in our sector, and we believe we have the plans and expertise in place to win in today's retail environment.
The good news is, I've not encountered any issues or business problems in my last 99 days at Lowe's that I have not experienced before. Therefore, I'm confident in our ability to develop a world-class operational focus. Thank you, and I will now turn the call over to Dave Denton.
Thank you, Joey. Good morning, everyone. While I know many of you from my past, I look forward to working with all of you as we position Lowe's for long-term financial success. While today is technically my first official day as CFO, over the past several weeks, I've spent a great deal of time immersing myself in the business. I've engaged with both the executive leadership team as well as the finance team here at the company. I've had the opportunity to both review and participate in the ongoing strategic planning efforts. I strongly believe the company is taking the necessary actions to be well-positioned for success in both the near and long term. I've grown to appreciate the strong fundamentals of the home improvement market, driven by robust real residential investment and home price appreciation.
Yet I've seen the existing challenges facing the Lowe's business. I've come away from the past few weeks with tremendous excitement about the future and believe we can create significant long-term value for all stakeholders, including both shareholders, customers, and associates. This morning, I'll spend a few minutes reviewing the company's financial performance in the third quarter and provide an overview of our expectations for the balance of this year. As a reminder, in the first quarter of this year, we adopted the new revenue recognition accounting standard, and as a result, we reclassified certain items within operating income. The most significant of which was the reclassification of the profit-sharing income associated with our proprietary credit program from SG&A to sales. The adoption of the standard had no meaningful impact on operating income and no impact on comparable sales.
Also, it was adopted on a modified retrospective basis, the prior year has not been adjusted. Also, before I review the underlying operating performance of the business, let me briefly discuss the pre-tax charges taken during the quarter. As described in the press release this morning, our strategic reassessment has resulted in $280 million of pre-tax charges. These charges were incurred to reposition Lowe's with the objective of improving the company's financial returns and to allow the organization to focus on the key drivers of long-term value creation.
Specifically, these charges include $123 million associated with our decision to close all Orchard Supply Hardware locations, $121 million related to our decision to close certain underperforming stores in the U.S. and Canada, along with a few other Canadian locations, $22 million related to our decision to exit retail operations in Mexico, and $14 million related to our decision to exit Alacrity Renovation services and the Iris smart home business. The $280 million in pre-tax charges can be classified into a few major expense categories. These include approximately $130 million of long-lived asset impairments, $15 million in lease obligations, $103 million in accelerated depreciation and amortization, and $32 million in severance obligations. Given the nature of these expenses, we estimated that the net future cash outflows will be approximately $50 million.
I'll now turn to a review of our operating performance for the quarter, starting with our capital allocation program. In the first nine months of 2018, we generated nearly $6 billion in free cash. Through a combination of both dividends and share repurchases, we've returned approximately 60% of this cash to shareholders. In the third quarter alone, we paid $390 million in dividends, and our dividend payout ratio currently stands at 35% over the trailing four quarters. In August of this year, we entered into a $310 million accelerated share repurchase agreement, which settled in the quarter, retiring approximately 2.8 million shares. We also repurchased approximately 2.9 million shares for $310 million in the open market. In total, we repurchased $620 million of our stock in the quarter.
This brings our year-to-date share repurchases to $2.5 billion through the end of Q3, with a plan to repurchase $3 billion for the year. We have approximately $4.5 billion remaining on our share repurchase authorization. Importantly, we continue to invest in our core business with capital expenditures of approximately $300 million in the third quarter and nearly $850 million year-to-date. We are very deliberately managing our capital expenditures, focusing on investing in areas that both stabilize our business and generate healthy long-term returns. Now looking at the income statement, we generated GAAP diluted earnings per share of $0.78 compared to $1.05 in the third quarter of LY. On a comparable basis, excluding the $280 million in pre-tax charges associated with our strategic reassessment, adjusted diluted earnings per share was $1.04 a share, a 1% decrease over last year's earnings per share.
Despite softer sales in the quarter than anticipated, the $1.04 of adjusted earnings per share beat our expectations. The better-than-planned performance was a result of a lower effective tax rate and better margin performance from our inventory rationalization activities. Sales for the third quarter increased 3.8% to $17.4 billion, supported by an average ticket growth of 4.5% to $75.89, partially offset by a roughly 1% decline in total transactions. Adoption of the new revenue recognition standard provided a 143 basis point benefit to sales growth. Comp sales were 1.5%, driven by an average ticket increase of 2.3%, partially offset by a transaction decline of about 1%. As the team has shared, we continue to see strong traffic growth in the third quarter. However, challenges with inventory out of stocks, poor reset execution, and assortment concerns in certain categories pressured our ability to turn those visits into transactions.
During the quarter, the net effect of cycling the hurricane season was approximately 100 basis points drag on comp sales. Headwinds from Hurricane Harvey and Hurricane Irma were partially offset by demands from Hurricane Florence and Hurricane Michael. Our inventory rationalization efforts in the quarter provided an approximately 15 basis points benefit to comp sales. Looking at monthly trends, comps were 4% in August, 0.7% in September, and essentially flat in October. Excluding the estimated net negative impact of hurricanes and adjusted for the estimated pull-forward impact of our inventory rationalization efforts, our monthly comps were 3.7% in August, 1.9% in September, and 1.7% in October. Gross margin for the third quarter was 32.5% of sales, a decrease of 157 basis points from Q3 of LY. Again, adoption of the new revenue recognition standard provided 107 basis points benefit to gross margin.
Our efforts to aggressively rationalize inventory and to eliminate slow-moving or underperforming SKUs negatively impacted gross margin by 180 basis points. This effort was an important step in better positioning the company's inventory to foster long-term sales growth and ROIC improvement. We also experienced 35 basis points of additional pressure from reset-related clearance activity and 25 basis points from clearance activity from the wind-down of our Orchard Supply Hardware operation. Finally, product mix shift had a 10 basis points negative impact on gross margin in the quarter. SG&A for the quarter was 24.5% of sales, which delevered 180 basis points. Again, adoption of the new revenue recognition standard resulted in 118 basis points of SG&A deleverage. Additionally, pre-tax charges in the quarter related to our strategic reassessment drove 105 basis points of deleverage as well.
These items were partially offset by 20 basis points of leverage due to incentive compensation and 15 basis points of leverage from a favorable employee insurance adjustment. Depreciation and amortization for the quarter was $433 million, which delevered 36 basis points, again, primarily as a result of the accelerated depreciation related to the exit of Orchard Supply Hardware. Operating income decreased 373 basis points to 5.5% of sales. Our effective tax rate was 21.8% compared to 37.1% LY. This significant improvement is largely the result of tax reform as well as a few other discrete items that were recorded in the quarter. Quickly, let me highlight a few items related to the balance sheet. Inventory at $12.4 billion decreased $28 million, or 0.2%, versus the third quarter of last year. Again, primarily the result of our inventory rationalization activity.
Inventory turnover was 3.84 times, a decrease of 10 basis points versus Q3 of LY. At the end of the third quarter, lease-adjusted debt to EBITDA was 2.29 times, and our return on invested capital was 19%. Looking ahead, I'd like to address several updates that we've made to the Lowe's business outlook. As Marvin shared, the home improvement backdrop remains strong, driven again by robust real residential investment and home price appreciation, which continues to encourage homeowners to engage in discretionary projects. As you well know, 2018 continues to be somewhat of a rebalancing year for Lowe's, as we are refocusing the organization to both enhance returns and drive shareholder value. As a result of our strategic reassessment of the business and the ongoing execution challenges, we have updated our expectations for the balance of this year.
We now expect a total sales increase of approximately 4% for the year, driven by comp sales increase of approximately 2.5%. We anticipate opening eight stores. On a GAAP basis, we expect an operating margin decline of 240 basis points-255 basis points. This includes charges of 135 basis points-150 basis points associated with our strategic reassessment of the business. As a reminder, we incurred $230 million of pre-tax charges in the second quarter, $280 million in the third quarter, and expect an additional $460 million-$580 million in the fourth quarter. Keep in mind that the amount, the nature, and the timing of any additional charges associated with the exit of our retail operations in Mexico will depend on the plan executed and therefore have not been reflected in our business outlook. The effective tax rate is expected to be approximately 24%.
For the year, on a GAAP basis, we now expect diluted earnings per share of $4.08-$4.24 per share. Excluding the impact of the charges associated with our strategic reassessment, adjusted to earnings per share is now expected to be $5.08-$5.13 a share. We are now forecasting cash flows from operations of approximately $6.7 billion and capital expenditures of approximately $1.2 billion. This is expected result in free cash flow of approximately $5.5 billion for 2018. Our guidance assumes approximately $3 billion in share repurchases for the year. Again, we remain excited about the future of our business and we are focused on taking the necessary actions to drive returns and shareholder value. With that, we'll now open it up for questions.
We are now ready for questions. To ask a question, press star 1 on your telephone keypad. To withdraw your question, press the # key. In order to allow questions from as many individuals as possible, please limit yourself to one question and one follow-up. Our first question comes from the line of Michael Lasser with UBS. Please go ahead.
Good morning. Thanks a lot for taking my question. If we look at your performance relative to your large competitor or relative to the category, you clearly took a step back this quarter. Now, I don't think anyone thought it was going to be easy, but Marvin, when can we expect to see some progress from Lowe's by narrowing these gaps to your competition?
Okay. Michael Lasser, I think for us, I stated this in the prepared comments, we're really focused on creating a sustainable foundation in the third quarter. We made a conscious effort not to chase short-term fixes or short-term results. In any quarter, retailers can make decisions on promotional cadence and special buys, those types of tactical things. We stayed away from all of those types of decisions because I wanted to give the team the appropriate time to really get to the root cause. That's why I think it's appropriate to know that both Bill Boltz and Joe McFarland are celebrating their 99th day with the company today. Although we've made great strides in our reassessment of the business, we have a lot of really new executives. Having said that, we have an expectation that we're going to see the business improve going into 2019.
We're also expecting some short-term improvements in the business just based on all the actions that the team has taken some of the initiatives put in place in the third quarter. Some very fundamental things that we're looking at that we think will deliver some short-term results will be just a simple improvement in customer service. Joe McFarland talked about how removing tasks and designating service versus task time, those things are important. Bill Boltz talked about bringing some level of productivity to our end caps. Our end caps in the past have been used for billboards, not real sales productivity. We think just that simple transition will add some value. The improvements we've made in the supply chain, how we now have better coordination between supply chain and stores, as we'll improve our in-stocks and we'll see incremental improvement.
To answer your question specifically, we were not chasing short-term results in the quarter. If there's an expectation that some of these chronic longstanding issues can be fixed in a couple of months, that's really unrealistic. Rather than trying to chase quick fixes, we want to fix it at the root, we think we're doing that. That's why we believe that going into 2019, you'll see this company start to have sustainable improvement month-over-month, quarter-over-quarter.
Marvin Ellison, as you head excuse me. As you head into 2019? What's the chance that any sort of gains you make with the self-help and addressing some of the execution issues are simply just offset by what will probably be a tougher industry environment next year? How are you preparing for that?
I think for us, the great thing about our business is that we're in a $900 billion fragmented home improvement marketplace. If you combine us and our chief competitor, that's less than $200 billion in revenue. There is a lot of market share up for grabs. We have been very transparent on the issues that we are dealing with as a company. Most companies are not going to be as transparent. The reason why that's important is because when we fix these very long-standing chronic issues, poor reset execution, out-of-stocks, assortments not being localized, poor customer service, no real focus on the pro customer, irrespective of what could happen with our competitor or competitors, plural, we have market share opportunity just because we've been underperforming as an individual company in a massive marketplace where we have about 10% share.
We're not as concerned with what's happening in other places, and not even the macro, because we feel really good about the macro environment for home improvement. This is really more about us understanding the steps we need to take to improve our execution, and the team will lay out some very specific short and long-term initiatives at our December 12th Analyst and Investor Conference.
Great. Thank you so much.
Your next question comes from the line of Christopher Horvers with JPMorgan. Please go ahead.
Thanks. Good morning. Can you talk a little bit about the 180-basis-point headwind for the inventory clearance and reconcile that to the sort of 15-basis-point lift to sales from clearance? Is there any assumption in there on ticket cannibalization, sort of stealing a more full price sale, and thereby sort of diminishing the comp lift from that clearance activity?
Yeah. Chris, the one reason why a retailer never desires to have a massive inventory liquidation process is because it really wreaks havoc on your numbers. As Dave stated in his prepared comments, we believe that we saw some comp benefit early in the quarter from the inventory liquidation because it was being sold at a higher average ticket. As we got into the month of October, when we started to see the liquidation at its most aggressive cadence, we believe that not only did it hurt average ticket, we think it cannibalized sales. I remember, as an antidote, being in a store and seeing a heater being clearance in the month of October, and I thought that was very odd.
After we followed up, I realized that that was a heater from two seasons ago that had been trapped in the overhead because it had never been properly clearanced out. If you think about that for a second, October is a time where we're really selling heating at a very high rate. If you can trade down and get a unit that's roughly 60% to 70% off, it's going to cannibalize regular ticket items. We think it may have benefited us at the beginning of the quarter from a comp standpoint, but as the quarter progressed, specifically October, we think it was a negative impact.
Hey, Chris, this is Dave. I think the good news is while no company likes to liquidate inventory, we had about $500 million to liquidate. That's now largely behind us, so we're now positioned going into the back half of the quarter and into 2019, kind of clean from that perspective. I think we're well-positioned to put the right inventory in the right locations to begin to improve performance.
Understood. I guess, just as a devil's advocate question, you've talked about conversion issues at Lowe's, I guess my question is, how do you necessarily know that that sale would have been made, if it weren't for that aggressive discount on the product?
Well, Chris, our conversion issues were less about the liquidation of inventory and more about just being out of stock. This is a very simple retail analysis. When customers walk into a brick-and-mortar location, they have an intention to either buy or to get some level of consultation on an item they're considering buying. We're in the project business, so that happens quite often. When we talk to our customers and ask the question, what drove a decision not to buy when you physically showed up at a store, it is overwhelmingly that you were not in stock. Our conversion issues had nothing to do with the inventory liquidation. It had everything to do with the fact that we had four very problematic resets underway, and we still have a significant number of out-of-stocks on our shelves.
You could just simply walk our stores and see it with the naked eye. As Joe McFarland mentioned, we put some operational processes in place that's going to help us to improve this. Out-of-stocks is also something you can't flip a switch on unless you're going to make some aggressive short-term decisions like air freighting in product or making some bad short-term decisions. We chose not to do that, and we're actually fixing the reset process with an internal team that's going to own resets. We're having better coordination between supply chain and store operations, and we have a consistent in-stock process in the stores. Conversion for us was driven almost exclusively by out-of-stocks. We're going to continue to just execute and improve in-stock, and we think our conversion will improve accordingly.
Understood. Just one quick one for the model. How should we think about depreciation going forward? Thank you.
I think if you look at Q3, if you back out the charges that I indicated from my prepared remarks, it should be fairly consistent going forward. It will depend a little bit about what we do with Mexico and the ultimate disposition of that business.
Got it. Thanks.
Thank you.
Your next question comes from the line of Simeon Gutman with Morgan Stanley. Please go ahead.
Thanks. Good morning. Maybe I missed it, but did you quantify how much you think all the reset activity and the out-of-stocks hurt your comps in the quarter?
We did not.
Do you have a guess or is it too difficult to gauge?
Simeon, I've learned that guessing is probably not a good thing to do on an earnings call. What I'll tell you is, it is a little too difficult to gauge. We spent most of the time, quite candidly, trying to get to the root cause of why these issues exist. Bill Boltz and his team spent a lot of time understanding supply issues, supply coordination issues, third-party reset issues, just in-store planning. We feel really good about the fact that we've identified the root cause. We're really focused our time and attention on now trying to put those plans in place to solve those issues.
We'll have a much more detailed and specific overview of this on our December 12 analyst investment meeting because we felt it was important to make sure that we communicate externally how we're solving this, because we've spent time on the last two calls talking about it being a chronic issue. Now we want to spend time about the steps we're taking to correct it.
Okay. I guess within that question, I think paint, this category has been affected I think for two quarters in a row. I figure maybe you have some guesstimate around on that business. Then maybe a way to think about it is, can you tell us what the comps were in the categories that weren't affected? For the answer, I would exclude probably outdoor and seasonal, just given that there was probably some hurricane stuff noise in there. If we look at traditional categories, you did mention some above average, some at company average, but maybe you can give a little more color on the other categories that didn't have some type of reset activity.
Well, Simeon, I think for me, the best way to answer your question is that we had four negative comping categories for the quarter. All four had reset interruption issues. That's probably the most effective way to answer the question. Where we did not have reset issues, we had positive comps. Where we had reset issues, we had negative comps. I think to me, that's the best explanation of the impact of poor reset execution on the business. I think anything beyond that would just be data that may not be useful.
Fair enough. Okay. My real follow-up is, you mentioned to us, I think it was in September, that there were a couple of pro brands that Lowe's didn't have, and I forget, you didn't name the brands. I don't know if you could share with us what it is. What's the visibility on that and trying to get new brands, does that take a back seat now to you fixing some of the core operations of the business?
I'll do two things. First, we're always going to talk about the brands that we have and the brands that we're very proud to have, and I'll let Bill talk about some of those pro brands. I'll just say for the record, the brands that we don't have that we desire to have, we're actively working to try to get them in our assortment. We will just take the practice of only talking about the brands we have because those are the companies we want to highlight. Bill, just talk a little bit about some of the pro brands that we feel really good about that performed well in the third quarter.
We're excited about what happened with water heaters and A. O. Smith. We're very excited about what happened with SharkBite, as I mentioned in my prepared remarks around the SharkBite plumbing fittings. We finished the rollout of Zoeller Pumps. We finished the rollout of our tile setting material under MAPEI. We introduced new pro cordless products under Bosch and Metabo HPT. As good merchants, we'll continue to evaluate assortments and look at where those opportunities are going forward and try to make sure that we're doing our best to offer the products and the brands that the customers want.
Thanks.
Thank you.
Your next question comes from the line of Steven Forbes with Guggenheim. Please go ahead.
Good morning. I wanted to start with the five P priorities you mentioned within the merchandising and store operational functions. Not to take too much from the Analyst Day, but can you briefly address sort of the anticipated timing of the completion of these initiatives? Is it a first half, second half 2019? Just some general idea on the timing of the initiatives would be helpful.
Steve, I'll hand it over to Bill and let him go first and then ask him to keep it high level because as you can imagine, we're still working on some of the really specific details of these. Although these initiatives were launched in the end of the third quarter, there's still some specific details we're working on. I'll ask Joe to appropriately stay a little high level on operations as well. Bill can talk about those priorities for merchandising.
Yeah. We're continuing to evaluate talent and to bring in experienced leaders, and so that will continue as we go into the early part of next year. We want to have that done, obviously, as quickly as possible. As we work through some of the merchandising opportunities, some of those categories I called out in my prepared remarks that will take us longer, some of those will take into the back half of 2019 because of the complexity. The ones that we can get done sooner, we'll obviously implement it as early as we can in the early part of 2019. We'll take them as they come and continue to work through them on an issue-by-issue basis.
Okay. Joe, you want to talk about ops real quick?
For store operations, what I would say is we have identified all of the challenges that we have. Certain things like a simple process for receiving trucks, customer service, we have already begun implementing those. As we think about the new payroll allocation system, we've already taken initial steps. However, that will flow into 2019. I'd say we're well underway, that we have identified all the root causes, and we're excited to share more as we get together in December.
Thank you. Just a quick follow-up for Dave. You called out a bunch of the margin dynamics right during the quarter for gross margin. What about rise in transportation cost and supply chain cost? Can you quantify that drag this quarter?
Yeah. We've been watching that closely. Like all industry participants in this sector, transportation cost is a worry. I'd say that as we looked at our forecast for the balance of the year, we've included that in our guidance. I would say it's not a significant headwind at this point in time, but it's something we're watching closely as we cycle through the balance of this year and into next year.
Thank you.
Thank you.
Your next question will come from the line of Zachary Fadem with Wells Fargo. Please go ahead.
Hey, good morning. With your strategic review coming to a head, Marvin, could you talk about how your findings compared to your expectations going in? I'm sure you had some ideas around what needed to change. I'm curious if you could speak to areas within your business that are maybe functioning better than you expected. For those areas underperforming, how does the magnitude of change needed compare to what you initially thought?
Okay. Zach, what I've been most pleased with is really the people side of the business. As I said in my prepared comments, we don't make it easy on our associates. We spent a lot of capital as a company over the last seven years, but we haven't necessarily spent a lot of capital on making the stores more efficient, making our supply chains modern, and just creating a easier work environment for our associates. Our associates have been resilient, and I've visited all of our geographic markets, including Canada and our MSH operation for Pro. In every case, I just walk away just being encouraged by our associates. I've mentioned the engagement with the community. We're serving 50,000 meals today for Thanksgiving for communities affected by the hurricane. This is a kind of a thing that I had no real impact on.
It was just happening when I got here. That's part of the associates loving the business and the culture. I would say, the decisions we've made rather quickly were around leadership structure and organization. I felt that we needed to bring in some core retail experts. What I've learned in my successes and failures in retail is that when you're solving problems, it is best to go out and find leaders who've kind of been there, done it before. That's why when I look around the table at Don Frieson in supply chain and Bill Boltz in merchandising and Joe McFarland in stores and Dave Denton as our CFO and Seemantini as our new Chief Information Officer, et cetera. We've gone out and recruited world-class leaders who've kind of been there, done it before, and that's required.
I won't say I was disappointed in what I found, but I felt like the need to bring in experienced leaders so that we could solve these problems quickly. I also, I just wanted to make sure that we had a more disciplined capital allocation process. As I mentioned earlier, a lot of the strategic reassessment in closing underperforming stores, exiting non-core businesses, getting out of environments where we can't really be competitive because we can't get the scale like Mexico, is all a part of making sure we reallocate capital and invest in creating a great home improvement retail environment. That's kind of where we are, and we'll continue to make the necessary changes, but we feel great about the future of this company. We can identify obvious shortcomings in what we're doing on a daily, weekly basis.
We can look at where we're underperforming from a sales perspective, and we can point exactly to what's causing it. To me, that's very encouraging because we know how to fix it. We're going to continue to push forward.
Got it, Marvin. Thanks. That's helpful. Then quick one for Dave. First of all, welcome aboard. Then on the store closings and the additional initiatives announced today, curious if you could speak to your approach to some of the cost savings coming out next year and how do you think about just the process of redeploying and reinvesting those savings? Are there any of those savings that you would expect to drop to the bottom line next year?
Obviously, we're making these investments and these decisions to position the company for long-term financial success. There's no doubt about that. I think the team's really focused against that very intensely. I do think that the savings that are going to be generated from these activities are partly going to be invested a little bit as we think about repositioning the company and some of the efforts you heard from both Joe and Bill today. Importantly, as we think about the future and the future growth and the returns on the business that we have today, this will largely fall to the bottom line and really enhance those returns over the next future periods.
Got it. Thanks so much, guys. I appreciate the time.
Thank you.
Thank you.
Our next question will come from the line of Greg Melich with MoffettNathanson. Please go ahead.
Great. A couple questions. Just want to make sure I piece together the guidance and the inventory adjustments right. If I got it right, there's $320 million of inventory hit in Q3, and I think, Dave, you mentioned around $500 million over the course of the year. If we think about either of those numbers, it's sort of 60-90 basis points of margin hit this year. Should we be thinking about that as the-- If there was 135-150 basis points of charges, right, mostly non-cash, that really this year, EBIT margins are down 90-100 basis points, but that inventory is 60-90 of it, and that that's sort of a clean like-for-like slate into next year? Am I piecing that together right?
Well, a little bit. Let me just step back a minute. We had roughly $500 million of inventory to clear. We roughly cleared that at a 40% discount. I think that's largely behind us. As we cycle into Q4, we're essentially clean from an inventory rationalization perspective. Don't think about a hangover into Q4. Think about that being complete in Q3.
Got it. If we take just Q3 and that's now behind us and that what we saw in the gross margin, that $320 million-$330 million is when we get to next year, now we're clean-
That's correct.
When we think about it, sort of a run rate of margin. Great. Second, sort of bigger picture on just traffic and conversion. I think, Marvin, you mentioned that traffic was still positive, but we basically have transaction counts down. How do you measure what traffic really was versus that conversion? I mean, was it that store traffic was up 1%, but we were down transaction counts down 1%, and that's the difference in terms of close rate?
I think a couple of ways. Measuring traffic online is just pure data-driven, that's something we have 100% visibility to, like any other e-commerce or brick-and-mortar company with an e-commerce platform. That's pretty straightforward. When we look at traffic in the stores, we have monitoring devices to measure traffic. Our environment is more difficult to measure conversion because we're a project business. We're going to shift our discussion from conversion to transactions. I think that is a better way to understand a year-over-year comparison of our business. Having said that, we still feel very good about traffic, both online and in-store, based on how we measure it. We understand that we have challenges in driving transactions and/or conversion based on the traffic. You look online, we know we have some issues with functionality that we're addressing.
We also know that we have issue with search and navigation at ease of checkout. You look at our mobile app, you can see an app that desires to be much more robust, and we're in the process of delivering on that. We look in the store, I'll go back to my previous comments. We don't want to make this overly complicated. When a retailer is not delivering on the traffic that's walking in your store, there are really a couple of basic reasons why. Either you are pricing correctly from what you advertise or you're out of stock. We feel good about the consistency of our pricing and all of our data tells us that we're out of stock. That's why we put such a huge emphasis on addressing this issue.
We understand the root cause, we understand how we got here, and now we're working to create a sustainable solution to fix it.
That's great. Thanks. Good luck, guys. See you in a week.
Thank you. We're going to take one more question.
Our final question will come from the line of Scot Ciccarelli with RBC. Please go ahead.
Good morning, guys. Thanks for fitting me in here. I guess as this is a bigger picture view for a second as well. When you kind of look at your performance against The Home Depot, the bulk of the sales gap on a per store basis, Marvin, as we've talked about, is really on the pro side. If you were to get the stores right where you want them, the in-stocks where you want them, I know this is an opinion, but over what kind of timeframe do you think you would start to take market share back on the pro side? Related to that, why would a pro change who their incumbent product supplier is? Thank you.
No, Scot, it's a fair question. I'll speak specifically on the pro customer. The pro customer is a very important customer, but they're a very, very simple customer. This customer is looking for a couple of fundamental things. First, they're looking for a great price. They're looking for service that saves them time because time is money, and they're looking for the brands that they identify with. That's really it. They're pretty much agnostic on anything else. Lowe's has proven that you can have a dominant market share in pro and lose it, because at one point, Lowe's had dominant market share in pro, and they didn't maintain it because primarily of those three things I outlined were no longer competitive advantages. For us, we're going to make sure that we are competitively priced.
That's something that Bill and his team are taking the lead on. We're going to make sure that we have great service because, again, time is money, and service with a pro is not giving them product knowledge. It's about having job lot quantities. It's about giving them the ability to buy and stage product. It's the ability to load. It's the ability to speak their language and to engage them at the pro desk or engage them online. Now the 3 level is to go out and get the brands. As Bill and I both mentioned, we're actively engaged in trying to fill our assortment with brands that we currently don't have. When you do those things, the pro is totally agnostic to the channel in which they shop because it's all about those three things for them.
Do you think that if you match apples to apples, the pro would come to Lowe's instead of The Home Depot? Or does
Well, I think the key is we spend very little time looking across the street. We are a customer-centric company, and what we believe is if we take care of the customer, everything else will take care of itself. I'll just remind you that we operate in a $900 billion marketplace. We don't care a whole lot about what's happening across the street because between Lowe's and our largest competitor, it's less than $200 billion in market share, which means there's more than $700 billion up for grabs in this really fragmented environment. For us, it's less about what's happening with the competitors, more about how we serve customers, and how we go out, and we take share in this fragmented marketplace we're in.
Understood. Thanks a lot. Helpful.
Okay. Thank you very much. Look, we appreciate your time and attention on the call, and we look forward to speaking to you again on our fourth quarter call, which will be Wednesday, February 27th. Thanks, and have a very blessed Thanksgiving.
Ladies and gentlemen, this concludes today's conference. Thank you all for joining, and you may now disconnect.