Good morning, everyone, and welcome to the Lowe's Companies third quarter 2012 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. 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. Also, during this call, management will be using certain non-GAAP financial measures.
You can find a reconciliation to the mostly directly comparable GAAP financial measures and other information about them posted on Lowe's Investor Relations website under Investor Documents. Hosting today's conference will be Mr. Robert Niblock, Chairman, President, and CEO, Mr. Greg Bridgeford, Chief Customer Officer, and Mr. Bob Hull, Chief Financial Officer. I will now turn the program over to Mr. Niblock for opening remarks. Please go ahead, sir.
Good morning, and thanks for your interest in Lowe's. Following my remarks, Greg Bridgeford will review our operational performance, Bob Hull will review our financial results in detail. First, let me express our sympathy for all those impacted by the devastating effects of Superstorm Sandy. I also want to express my sincere appreciation for the Lowe's team members who have worked so diligently to get supplies to the affected area, both before and after the storm. For those who are working diligently to staff and support our stores as we help communities recover from the damage. While roughly 200 of our stores were in the affected area, we only had one store that remained closed for an extended period of time due to severe water damage. That store in Rosedale, New York, reopened last Wednesday and stands ready to assist the community.
As we've done in the past, when natural disaster strikes, Lowe's stores around the country, as well as lowes.com, become official donation sites for the American Red Cross Disaster Relief Fund. Lowe's is contributing $1 million to the relief efforts through the American Red Cross and other partner organizations. Turning now to our operating performance. We're keenly focused on improving our core business. In the U.S., we're focused on two large bodies of work this year, value improvement and product differentiation. Together, they will enable us to compete more effectively in the current macroeconomic environment. These focus areas build on Lowe's core strengths and are expected to deliver comp transaction growth and better gross margins by localizing assortments, driving excitement in our stores through better display techniques, and managing an appropriate balance of product cost and retail pricing. We continue to make progress and are encouraged by early results.
By mid-2013, we will have completed this work and expect these efforts to provide meaningful comp and gross margin benefits. As I've said, we are focused, and our level of execution is improving. In the third quarter, we furthered our efforts to strike the right promotional cadence, drove more items per ticket, and made tough decisions in order to manage capacity and further our progress on value improvement. We delivered solid results for the third quarter. Comparable store sales were positive 1.8%, with a slight increase in comp transactions and a 1.6% increase in comp average ticket. 12 of 14 product categories ended the quarter with a positive comp. In fact, nearly two-thirds of the categories generated comps above the company average, including big-ticket categories such as cabinets and countertops, and appliances.
Building materials was the only significant drag in the quarter, which resulted from the headwind we faced from last year's substantial tornado and hurricane repairs. We continue to see strength in our commercial business, which outperformed the company average in the third quarter. Our commercial business is roughly 25% of our sales. Gross margin expanded 26 basis points in the third quarter, driven by a number of factors that Bob will discuss, including benefits from our value improvement program. We continued to effectively control operating expenses in the quarter and delivered earnings per share of $0.35, which included approximately $0.05 of charges related to long-lived asset impairments, discontinued projects, and the change in the discount rate applied to self-insurance claims.
Delivering on our commitment to return excess cash to shareholders, in the third quarter, we repurchased $850 million, or 29.6 million shares of stock and paid $184 million in dividends. Recent news regarding the housing market indicates that it is on the mend, which provides a glimmer of hope in what has been a sluggish recovery. Overall, consumers remain cautiously optimistic as they perceive the path to recovery to be a bumpy one. According to our most recent consumer sentiment study, the majority of homeowners indicate that their spending is staying the same or declining compared to a year ago. Of those homeowners who continue to delay home improvement projects, the majority report a lack of income growth as the primary reason, and almost half cite a reluctance to use financing. As we look out into the fourth quarter and early next year, we considered that backdrop.
In fact, according to our study, the overwhelming majority of projects planned in the next three months are for tickets under $500. This further underscores the importance of the work we're doing around value improvement and product differentiation to drive transactions. You will hear more about our focus areas and our commitment to deliver better customer experiences at our Analyst and Investor Conference on December 5th. Thanks again for your interest. Greg?
Thanks, Robert, and good morning, everyone. I'd like to dive a little deeper into our quarterly results and update you on the progress of our two focus areas, Value Improvement and Product Differentiation. During our second quarter call, I emphasized our focus on driving improved results over the short and midterm. I'm pleased that in the third quarter, we showed sequential improvement from our second quarter comp and margin performance as we enhanced our promotional planning and execution and began to benefit from Value Improvement resets. As Robert noted, 12 of our 14 product categories had positive comps. I'd like to highlight a few. Within lawn and garden, we were prepared with ample inventory to help customers rebound from the second quarter heat and drought, and we drove improved attachment rates with strong sales in live goods, fertilizers, soil, rocks, and mulch.
Paint continued to benefit from its Value Improvement line review and reset, in which we developed four new color collections, one for each season, and introduced pre-mixed samples in clear sample jars. We also simplified our offering of paint applicators, creating a bay that is much easier for the customers to choose from, providing national brands where they are valued, and offering a clear progression of features and brand relevance at increasing price points. In big-ticket categories, such as cabinets and countertops and appliances, we drove positive comps and higher gross margin rate by more effectively managing promotions. While lumber had the highest comp in the quarter, it was mostly driven by inflation. On the other hand, building materials finished the quarter with double-digit negative comps as it continued to face headwinds from last year's substantial tornado and hurricane repairs.
Tools and outdoor power equipment and hardware showed a solid performance throughout the quarter, but particularly benefited from storm preparations during the last week of the quarter, when we supplied large quantities of generators, flashlights, and batteries to customers preparing for Superstorm Sandy. Our merchant, logistics, and store teams worked closely together to identify what products would be needed before and after Sandy and pre-stage them in appropriate stores and distribution centers. As it relates to our business, most major storms have four distinct phases. First, preparation, when customers buy products in anticipation of the storm. Second, impact, when the storm actually causes damage. Third, cleanup, when customers clean up their properties and assess the damage. Fourth, recovery, when they begin to make repairs and replace objects lost or damaged in the storm. Our third quarter included preparation, impact, and some initial cleanup from Sandy.
During the impact phase, over 140 stores in the immediate area had their normal operating hours impacted, and surrounding stores experienced reduced traffic. We expect cleanup to continue into the fourth quarter and recovery to begin in the fourth quarter and extend into 2013. Bob will share further details about the effect of Sandy in his comments. Turning to our strategic focus areas, our most immediate priority is to improve our product sales business model through our Value Improvement program. As a reminder, through this initiative, we are seeking to improve our product line designs, making them more relevant to each of the markets we serve, easier for customers to shop, and more efficient for our associates to maintain.
This includes reducing duplication of features and functions within price points and reinvesting inventory in key high-velocity items customers expect us to have in stock, including job lot quantities needed to complete large projects. We are also working to lower first costs through more disciplined line reviews and by redirecting vendor promotional and marketing support dollars to lower unit costs. We made good progress in the third quarter and expect to complete line reviews representing approximately 90% of our business by the end of the fiscal year. We are exceeding our inventory reduction goal and are making further progress relative to our cost reduction goal. We expect to reset 40%-50% of our business by the end of the fiscal year. The resets associated with the line review process are peaking now in early fourth quarter.
I have been pleased with our ability to mitigate disruption through increasingly efficient execution of these resets. Our team of in-house product service associates has reset products during non-peak hours, and the cross-functional value improvement team has used our markdown optimization tool to minimize the margin dollar impact from clearance product sales. In fact, despite clearance sales increasing by more than 80% in the third quarter, the clearance impact overall gross margin rate was roughly the same as last year. Keep in mind that the financial benefit of value improvement is greatest once we are past clearance and have begun selling only new assortment products. I would like to share the performance of the product lines that are past the reset and clearance process.
For these product lines, we estimate that we have obtained an average mid-single-digit comp sales lift and nearly a full percentage point improvement in gross margin rate, while also reducing inventory. Our customer surveys indicate that the perception of our product availability has improved over the third quarter of last year. To provide more color, I would like to share some initial results from our tile reset. This is a great example of where we used the accelerated line review process to improve the design of our lines through consumer insights, worked with vendor partners to generate innovative product and display ideas, used new analytical capabilities to tailor our offering to each market, and simplified our assortment to make it easier for customers to choose the right products for their needs. Our merchandising team started with consumer insights.
Tile customers generally want trend-relevant styles and high quality at a reasonable price, not brands. The team also used new analytical capabilities to group all domestic stores into 4 clusters, each with unique combinations of size, style, and color. The team set clear, specific, and firm expectations with our vendor partners to motivate them to bring great products and ideas to the line review. The result was that we were able to simplify the shopping experience while expanding meaningful options. For instance, we previously carried nine different SKUs in one particular size and color family, resulting in considerable inventory invested in multiple products that looked essentially the same. Offering this many SKUs overcomplicated the customer's decision. The solution. The team dropped some of the duplicate SKUs and added new wood looks in contemporary and larger-sized tile, which are more in line with current trends.
In total, we were able to reduce tile inventory by more than 20% through SKU and cost reductions, even while reinvesting in more inventory of our most popular SKUs and in new styles and sizes, making our tile aisle more inspiring and relevant for customers. Product differentiation is another focus area to improve operating performance. We've revised many of our end cap locations to highlight innovative new products and significant values leading into a category. We've also revamped the promotional spaces for drop zones to promote seasonally relevant high-value items to drive sales. To date, we've reset over 1,250 of our 1,700 domestic stores. The results of these changes in end cap and promotion spaces have continued to improve as we've adjusted the mix of end cap themes and improved the rotation of products.
We believe there are further opportunities to improve performance through better end cap item selection, increased depth of supporting inventory, and better adjacencies of end cap items to the associated end line inventory. As we progress through the fourth quarter, we expect to continue improving our execution of retail basics, continuing the momentum of our value improvement and product differentiation programs. At our Analyst and Investor Conference, I look forward to further describing these programs and sharing why they are so important to our core business. We will also discuss the development of new capabilities over the next 24 months to drive deeper, more meaningful relationships with home improvement customers. Thank you for your interest in Lowe's, I'll now turn it over to Bob.
Thanks, Greg, good morning, everyone. As noted in our earnings release, there was a week shift in fiscal 2012 as a result of 2011's 53rd week. Sales for the third quarter were $12.1 billion, which represents a 1.9% increase over last year's third quarter. The increase was driven by a comp sales increase of 1.8% and new stores offset slightly by the impact of prior year store closings and the calendar week shift impact, which we estimate to be $62 million, or one-half of 1%. In Q3, total average ticket increased 2.1% to $63.11, while total customer transactions decreased two-tenths of a percent. The decline in total transactions was due to the impact of the week shift. Looking at monthly trends, comps were four-tenths of a percent in August, 3.4% in September, and 1.3% in October.
For the quarter, comp average ticket increased 1.6%, comp transactions were up two-tenths of a percent. Transitioning to the comp drivers for Q3, lumber inflation aided comps by 65 basis points. We estimate that our focus areas, value improvement and product differentiation, drove 50 basis points of comp in the quarter. Additionally, we estimate that our proprietary credit value proposition, which offers customers the choice of 5% off every day or promotional financing, positively impacted Q3 comps by 40 basis points. We estimate that sales related to Hurricane Isaac and Hurricane Sandy this year were essentially offset by comparisons to sales related to Hurricane Irene last year. With regard to product categories, the categories that performed above average in the third quarter include lumber, tools and outdoor power equipment, lawn and garden, cabinets and countertops, paint, home fashion, storage and cleaning, appliances, and hardware.
In addition, fashion electrical, flooring, and plumbing performed essentially in line with the company average. Year-to-date sales of $39.5 billion represents a 2.3% increase over 2011. The increase was driven by a comp sales increase of 1.3%, a calendar week shift impact, which we estimate to be $192 million, or one-half of 1%, and a slight increase in square footage. Gross margins for the third quarter were 34.32% of sales, an increase of 26 basis points over last year's third quarter. The increase in gross margin was driven by a number of factors. Inflation helped gross margin by 14 basis points. Favorable distribution costs aided gross margin by 10 basis points. Our value improvement program helped gross margin by approximately 10 basis points as we more effectively managed promotional activity and began to realize the benefits from our product line review resets.
Slightly offsetting these items, our proprietary credit value proposition negatively impacted gross margin by nine basis points as the penetration of proprietary credit increased roughly 200 basis points over last year's third quarter to 25.1% of sales. Year-to-date gross margin of 34.3% represents a decrease of 36 basis points from 2011. SG&A for Q3 was 25.03% of sales, which deleveraged 224 basis points. In the third quarter, we incurred long-lived asset impairment and discontinued project expenses of $52 million. This compares to $356 million in similar charges last year, which included the charges associated with store closings. This resulted in 257 basis points of SG&A leverage in this year's third quarter. We experienced approximately nine basis points of leverage associated with our proprietary credit program, which was driven by higher portfolio income. Slightly offsetting these items was deleverage of contract labor, risk insurance, and incentive compensation expense.
Contract labor for information technology projects deleveraged 22 basis points in the quarter. This was driven by expenses related to our services platform project and timing of payments relative to last year. Risk insurance deleveraged 19 basis points in the quarter. We are self-insured for claims related to workers' comp and general liabilities. Due to the duration of the claims, we discount our liability. Given the current interest rate environment, we reduced the discount rate applied to incurred but not reported claims by 100 basis points in the quarter. This 1% reduction to the discount rate decreased insurance expense by $33 million. For the quarter, incentive compensation expense deleveraged 13 basis points. Our sales and service employee incentive program rewards hourly store employees for achieving their sales and profitability targets and for delivering outstanding customer service. Approximately 7% more stores earned an incentive in Q3 relative to last year.
Year-to-date SG&A is 23.91% of sales and leveraged 93 basis points to the first nine months of 2011, driven primarily by last year's long-lived asset impairments and other costs associated with store closings and discontinued projects. Depreciation totaled $371 million, or 3.08% of sales, and deleveraged three basis points compared with last year's third quarter. Earnings before interest and taxes, or operating margin, increased 247 basis points to 6.21% of sales. Year-to-date operating margin was 7.58% of sales. Interest expense at $114 million deleveraged 18 basis points as a percentage of sales. The increase in interest expense relates to debt offerings subsequent to our decision last year to increase our leverage target. For the quarter, total expenses were 29.06% of sales and leveraged 203 basis points. Pre-tax earnings for the quarter were $635 million, or 5.26% of sales. The effective tax rate for the quarter was 37.6%.
For the third quarter, we reported earnings per share of $0.35. The earnings per share impact of charges related to long-lived asset impairments, discontinued projects, and the change in the discount rate applied to self-insured claims was approximately $0.05 for the quarter. I'd like to comment on the balance sheet, starting with assets. Cash and cash equivalents balance at the end of the quarter was $1.1 billion. At the end of the quarter, inventory was almost $9 billion, which was flat to last year. Inventory turnover, calculated by taking the trailing four quarters cost of sales divided by average inventory for the last five quarters, was 3.75, an increase of 15 basis points over Q3 2011. Return on assets, determined using a trailing four quarters earnings divided by average assets for the last five quarters, increased 50 basis points to 5.74%.
I'd like to highlight a few items from the liability section of the balance sheet. At the end of the third quarter, our accounts payable balance was $5.4 billion, or 3% higher than last year. The increase in accounts payable relates to the timing of purchases. At the end of the quarter, our lease-adjusted debt to EBITDA was 2.17. Return on invested capital, measured using the trailing four quarters earnings plus tax-adjusted interest divided by average debt and equity for the last five quarters, increased 96 basis points to 9.39%. Looking at the statement of cash flows. Cash flow from operations was $3.5 billion. Cash used to acquire was $947 million, compared with almost $1.3 billion for the same period last year. As a result, year-to-date free cash flow was approximately $2.6 billion.
During the quarter, we repurchased 29.6 million shares at an average price of $28.68 for a total repurchase amount of $850 million. We have $900 million remaining on our share repurchase authorization. In Q3, we repaid $550 million of debt that had matured. Before I get into our business outlook, I want to remind everyone that fiscal 2011 was a 53-week year, which will impact our fourth quarter comparisons in two ways. First, the extra week contributed $766 million in sales to Q4 last year. This will negatively impact 2012 sales growth by 6.6% for the fourth quarter and 1.5% for the year. In addition, the extra week contributed approximately $0.05 per share to last year's diluted earnings per share. Second, last year's 53rd week caused a calendar week shift for fiscal 2012.
The calendar week shift positively impacted year-to-date sales by $192 million but is expected to negatively impact fourth quarter sales by the same $192 million, or 1.7%. The week shift is forecasted to negatively impact earnings per share by $0.02. The week shift has no impact on comp sales. For 2012, we expect total sales to be approximately flat to last year. On a 52 versus 52-week basis, the sales increase would be approximately 2%. We expect comp sales to increase approximately 1%. In addition, we expect to open approximately 10 stores, resulting in a slight increase in square footage. For the fiscal year, we are anticipating an EBITDA increase of approximately 40 basis points. We expect depreciation expense of about $1.5 billion. The effective tax rate is forecasted to be approximately 37.7%.
The sum of these inputs should yield an earnings per share of approximately $1.64, which represents an increase of 15% over 2011. As a reminder, our guidance is based on GAAP, the non-operating charges for long-lived asset impairments, discontinued projects, the change in the discount rate applied to self-insurance, and the voluntary separation program, which total approximately $0.08 per share, are included in the $1.64. For the year, we are forecasting cash flows from operations to be approximately $3.4 billion, which is modestly lower than our prior forecast due to working capital. Our capital forecast for 2012 is approximately $1.35 billion, with roughly $50 million funded by operating leases, resulting in cash capital expenditures of approximately $1.3 billion. This results in an estimated free cash flow of $2.1 billion for 2012.
Our guidance assumes approximately $550 million in additional share repurchases for a total of $4.15 billion for the year. For the year, we expect that lease adjusted EBITDA will be at or below 2.25 times. Regina, we are now ready for questions.
To ask a question, press *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 will come from the line of Scot Ciccarelli with RBC Capital Markets.
Hey, guys. How are you?
Hello.
Hi. Can you give us a little bit more detail regarding the comments about once you're past the reset and clearance stages, the mid-single-digit comp, how much of your SKU mix is that and how much did we actually see during the quarter, and what kind of timeframe are we talking about? Is this just over the initial two or three months, or do we have a longer track record than that? Thanks.
Sure.
Yes, Scot, that's the track record, since the categories that we've had go through reset have actually stabilized from an inventory standpoint. In other words, I don't have inventory flowing in to fill in the new set. I don't have inventory clearance that would be creating noise on the numbers. That is the continuing comp performance, the summation of that, through what now is about two and a half months of stabilization of categories. As I mentioned last quarter, we only had a handful of categories that had reached that, if you want to call it, normalization stage. In this quarter, we're seeing those results. About between three and four dozen categories have reached that normalization stage now, and more coming every week.
Greg, what is that on a % of mix basis, I guess? Three to four dozen categories out of I guess I honestly don't know what that's out of.
Sure. It's still in the range. We're still under 20% at this point of categories that have normalized.
Got it. All right. Thank you.
Thank you.
Your next question will come from the line of Budd Bugatch with Raymond James.
Good morning. Thank you for taking my questions.
You bet.
My first question, I know it's a little hard with the extra week, but can you give us a feel for the fourth quarter gross margin and SG&A? I know year-over-year will be a tougher comparison. Sequentially, how will that look, Bob?
Budd, yeah, there are a lot of moving pieces associated with the week shift impact. As you know, we had a significant drop in gross margin for the fourth quarter last year. We do anticipate an increase in gross margin in Q4 this year. The expected increase will be a bit larger than the 26 basis points that we saw in Q3. We're making continued progress on the line reviews. As Greg described, we're early in the process of resetting stores. We're seeing good benefit, but there's still a very small percentage that's been set to date. As we continue to reset additional lines, we'll continue to see greater improvement in both sales, the comp impact from those new sets, as well as gross margin.
Okay. Just as a follow-up, if you could, the rate of share repurchase has a bit slowed, and obviously, I think your guidance also gives additional slowing with the improvement in stock price. How do you think now about share repurchase going forward, and can you maybe give us a little color on that?
Sure. Our stock price certainly has improved today relative to the $2,868 average share repurchase price in Q3. As we take a look at our long-term financial performance, we still feel that the stock is attractive at the current price. The modest decline in share repurchases for the year really relates to the decline in cash flow from operations. As I mentioned, we've got a bit of a working capital drag relative to 90 days ago, but nothing substantial. That's contributing to the decline in that working capital as it relates to AP. It's just timing.
Okay. Thank you very much.
Bye.
Your next question will come from the line of David Gober with Morgan Stanley.
Good morning, guys. I just wanted to touch on SG&A a little bit. It seemed like excluding the charges, you saw some nice improvement there and actually a little bit of a decline year-over-year. Anything you could point to there and do you foresee that being sustainable over the next few quarters?
As we've talked about, we're working on a number of things to rightsize our cost structure. As we know, we took some actions last year, including store closings and realigning the field infrastructure. We implemented a voluntary separation program early this year. We continue to realign our corporate office. The store teams continue to evaluate opportunities to serve customers in a more efficient fashion. There's not any one thing I could point to, Dave. There's a number of things that are in flight that we referenced in a progression to 10% operating profit in 2015 at the analyst conference last year.
My follow-up is on Canada. Just wondering if you could comment at all. Obviously, there's been a bit of a saga there with the interest in RONA and then retracting the interest in RONA. Now, some movement in management at RONA. Could you just give us any updated thoughts on how you're thinking about Canada and maybe in particular RONA, given some of the changes there?
Yeah, Dave, it's Robert. Certainly, any comments with regard to any specific company would not be appropriate or anything about the change in management as to why that took place. It's not appropriate for us to comment on that. I think as we've said before, we like Canada from a market standpoint. We're pleased with the performance of our 32 stores. I think we've got a couple more opening before the end of the year. We're continuing to make improvements in the operations of those stores, but we need more scale. That scale, as we've talked about, is going to come from opening additional big box stores, looking at other formats.
We just launched in October our e-commerce site in Canada, that's a big plus, where now our consumers can buy online and have the product either shipped to their home or pick it up in store. I think we got over 30,000 items available on the website. We think that was a competitive disadvantage previously in the market, we'll also continue to look at acquisitions as a potential way for expansion. We're going to evaluate all options, but as far as any comments with regard to where we would stand with a particular company would not be appropriate for me to address.
Okay, thank you very much.
Your next question will come from the line of Colin McGranahan with Bernstein.
Good morning. First question on value improvement. It sounds like you said you're doing better than expected on the inventory reductions and making progress on value improvement. Can you give us an update on where you are, how those discussions have gone with vendors, whether you still think the endpoint's the same, and just a little bit of additional color on the progress you're making there?
Sure, Colin, this is Greg. Be happy to. We are making good progress on the inventory reduction efforts through the line review process. As we reset the lines, as you know, reinvesting a portion of that reduction back into the higher velocity categories. On the cost side, we have made good progress since we've begun the accelerated product line review rotation. To be honest with you, the way we're looking at this is that this is an ongoing commitment to discipline line review process. While we are focused on, we've talked about goals of inventory reduction in the 10% range and cost reduction in the 5% range. We recognize this is a long-term process to basically continually improve our entire operating model from the product sales standpoint, and it's not going to happen over a quarter.
This is a commitment to something that we're going to do within our merchandising logistics and operating ranks longer term. We're seeing continual progress as we continue to cycle through the first rotation of the accelerated product line review processes. We actually will come into 2013 and begin second cycles of some product categories.
Okay. Of the category department resets that are done, something a little under 20% of the product categories, are you achieving that endpoint in those categories, the 5% out of COGS? Is that you did expect to get there in the first wave and you get there over time?
We're making progress. We've exceeded our inventory goals, Colin. We are making progress towards our cost reduction goals. Obviously, there's about a half dozen product line reviews going on right now. It's good progress. I like the trends that we're seeing, it's a continual commitment to do this.
Okay. Fair enough. Then just quick follow-up. Obviously, we're all focused on how the performance of the reset categories is going. Of that 20% in two, three months, Greg, what kind of a standard deviation are you seeing there? Are you seeing pretty consistent results, or is it still all over, where some category resets are fantastic and others hardly see any lift?
No, I would categorize it into 2 buckets, Colin. I said we're below 20% right now. I wasn't giving 20% as a pinpoint, I'd categorize it into 2 buckets of product. One is inline, interior, or exterior, steady state demand type product. I would say that the paint example, the flooring example that we've been pretty public with are good examples of that. Hardware, rough plumbing, rough electrical. There are some seasonal categories and some commodity categories where we have seen more variability. That's expected. That's where we have seen the variability within the numbers. The steady state, more predictable demand categories are performing within a much tighter band, and they're performing above expectations.
Great. Thank you, Greg.
Sure, Colin.
Your next question will come from the line of Gregory Melich with ISI Group.
Hi, thanks. Two questions. One is the housekeeping. Could you give us the breakdown of the bigger tickets versus the smaller tickets and how they did? I had a cash flow question.
Sure, Greg. As you take a look at the ticket buckets, the below 50 were approximately a positive 1.3%. The above 500 were up approximately 2.5%, with everything in the middle being up roughly 1.6%.
Got it. On cash flow, earlier in the year, we started, I believe, with a $4.0 billion cash from operations estimate, I think it was three and a half and now three, four. Is there something going on with working capital that sort of made that one-off $600 million switch? Actually looks like working capital has been pretty good, especially this quarter. Help us understand how the cash from operations actually progressed this year.
Sure. If you go back to the beginning of the year, I think our initial estimate was that year-end inventory would be roughly $400 million below year-end 2011. The current estimate is about $200 million lower end of 2012 relative to end of 2011. Second, AP was a bit higher relative to inventory, up 3% in the Q3 against a flat inventory. As we forecast the timing of purchases for the year, it's still expected to be a modest drag relative to initial expectations. The third item, Greg, excuse me, relates to deferred taxes as we evaluated the impact of bonus depreciation last year. If you think about the large CapEx spend principally in IT, the opportunity to fully depreciate that in 2011 gave us a nice cash flow benefit in 2011.
We're now cycling against that in 2012, where book depreciation is in fact higher than tax depreciation. Those are really the three big drivers of the reduction in cash flow from operations relative to our initial expectations on the Q4 2011 call.
Would it be fair to characterize the first two as sort of a normal on the inventory and the AP, is that this year you'll be at a normal state given the line reviews and where you want the business to be?
What do you define as normal state of
Well, because with working capital, things can put and take, and it can be timing to a given year, right, or week. I guess, is that $200 million down in inventory, do you think that's now the right run rate for inventory, whereas before you thought it was $400? Has something changed, I guess, through the line reviews that would have made that change?
Generally speaking, yes, it's the normal course of business. It's the pushes and pulls of running a business. However, we talked about on the Q1 call, the cadence of the line reviews were going to take a little bit longer than expected. There's a small impact from that, but generally speaking, it is just the normal puts and takes.
Okay. Thanks a lot.
Thank you, Greg.
Your next question will come from the line of Christopher Horvers with J.P. Morgan.
Thanks. Good morning. On the gross margin side, you mentioned that the benefit, the categories that you reset, you saw 100 basis points improvement on the gross margin side. Can you talk about what components are in there? How much of that is big buckets, lower buying costs, lower markdowns, and is there any lapping of markdowns as you put those categories under initial line review in the prior year?
Chris, this is Greg. It is a combination of lower first costs through the accelerated product line review process. We're experiencing above expectation performance in gross margin of our non-productive inventory, AKA clearance items. I credit that to a joint effort on the part of the merchants, the logisticians, and the tremendous commitment by the operators to make sure that we sell through this clearance inventory at as much full margin as possible. The way it's been handled, we've been selling a lot of product in line and a lot of product off of a couple of promotional spaces or drop zones we've devoted to clearance inventory, and now a couple of end caps that we're devoting to clearance inventory.
Good success there, combined with a good positive first-cost reduction on key categories that we're seeing the benefit of through the accelerated product line review process.
Does that mean that as you cycle over time, that you would expect 100 basis points of gross margin expansion over the next however 12, 24-month timeframe?
It depends on the categories that are being reviewed at that time, Chris. You'll see some variation in that number, but our expectations of obviously first cost reduction through the product line review process. I think we've set some very good standards and excellent processes to drive the non-productive inventory gross margin productivity. I expect that to continue. You'll see some variation as different categories get reviewed through the oncoming months, before we begin to cycle our first series of these product line reviews, which was late last year.
Understood. Then as a follow-up, just on Sandy, you mentioned that Sandy and Isaac were neutral versus Irene a year ago. I'm not sure if you cut it this finely, but did October's 1.3% comp, did you actually see any lift there from Sandy? Do you expect Sandy to become a net positive in the coming quarters? Thanks.
Chris, as we take a look at the impacts for the quarter, Sandy helped about 30 basis points. Isaac helped about 30 basis points. Irene hurt about 65 basis points, so a modest drag from the aggregate of the three. We didn't go specifically determine the impact of Sandy on Q3. It would be hard to do the math on four weeks out of 13 weeks given the 30 basis points. Looking forward, we believe there is some upside related to Hurricane Sandy. We certainly want to be there for folks as communities rebuild. It's very difficult for us to estimate what the potential impact is going forward. As we have on later quarters, we'll tell you what the estimated impact was for that quarter.
Your next question will come from the line of Gary Balter with Credit Suisse.
Thank you. First of all, congratulations on a very solid quarter. Could you talk about the end caps, some of the programs that are working, some that you feel need to be changed and how that rollout has gone?
Sure. I will, Gary. This is Greg.
All right.
The couple of key categories within the end cap and drop zone programs that are all part of product differentiation that have been highlights in the program is the innovation end caps, where we're focusing effort to bring new products to the market. In some cases, new categories such as connected home through our launch of our Iris connected home platform for customers. The key to that is being able to demystify some of these innovations and bring customers interaction with them. The way that we've been able to communicate through running videos on the end caps have driven sales of those products actually in excess of expectations. The other category of end caps that have done very well are the value end caps.
The progress that I mentioned that I think we can make there are aligning them closer to the categories that they're home to and make them the pull-in to the categories, whether it's rough plumbing, whether it's lighting, whether it's a seasonal category, make sure that the adjacency is correct for that. We've not done the greatest job of that since we started the program. We're making improvements from that every month. As we cycle in new products, making sure that the adjacencies are stronger and that the items that we pick are more impactful. We've seen sequential improvement in the productivity, particularly in the innovation end caps, particularly in the value end caps, and in specific drop zones. We're taking that information and improving it every month as it goes along. It's run by a cross-functional team.
Lots of input from operations about what's working and what's not working, a lot of effort from logistics to make sure that we're backing those end caps with the proper amount of inventory.
What's not working in that area?
I think that, again, I'd say the adjacencies haven't been our strong spot. We have a heavy focus on that. We've made improvements in those in the last three months, as we cycle through the placement of new product, I would say that we've made big steps to correct that problem area. The other category that I would say that did not work very well were some of the theme end caps, such as Creative Ideas
It's a great concept. It's bringing together aspects of an entire project for the customer. In some cases, the effort to try to get a customer connect with the six different components of a product really railed against our mantra of keep it simple.
Just following up on that, where are you on the rollout of these end caps?
Creative end caps? Ideas end caps?
Yeah.
They're done.
Okay.
We took them out.
Thank you very much.
We're making running changes to them, make improvements in this particular program.
Your next question will come from the line of Daniel Binder with Jefferies.
Hi, it's Daniel Binder. My question revolved around your comment about the gross margin performance of the reset items. I think you said they were up about 100 basis points. If we look back last year, I think your gross margin was down about 55 basis points, and first half of this year down about 60 basis points. What I'm curious about is, are we essentially going to get back to where we were before the process began, such that the end result is really a comp driver more so than a gross margin driver?
Dan, I think the number was down 99 basis points, Q3 last year margin. The short answer is yes. If you think about the gross margin outlook that we shared at the analyst conference last fall, we still think those targets are appropriate. As Greg and team take a look at the line design, yes, there are certainly margin opportunities, but reconstructing the line design to be better market assorted should also drive top line improvement, which is what we're looking for. This wasn't intended to be solely a margin. It was having line design that was more reflective of the local market opportunity that we felt like we were missing.
Dan, this is Greg. Another positive impact on gross margin for the quarter was we stated at the end of the second quarter that we knew we could manage our promotional activities better and the focus on driving anchor items, which would improve attachment rates and balancing that with traffic-driving items. That was a keen focus in Q3, and it's paid off. I think our promotional efforts are much more accretive from a gross margin standpoint.
Right. Yeah, Bob, I was referring to all of last year on the 55 basis points, but just as a follow on, sometimes I think you guys will comment on how the beginning of the quarter is going. Any thoughts now that we're sort of well into the cleanup and hopefully some of the recovery on Sandy?
As we talked about, the estimated impact of Sandy is very difficult to estimate. We're watching mindfully of what's taking place with the fiscal cliff. We're also mindful of comparisons relative to last year, specifically a very difficult January. We're off to the start we expected to be, and we're comfortable with the outlook we just provided.
Great. Thanks.
Thank you.
Your next question will come from the line of Michael Lasser with UBS.
Good morning. Can you talk about the puts and takes on your traffic during the third quarter? Are you starting to see the housing recovery benefit your traffic? It was seen to be up just slightly during the period.
Michael, was up 0.2% in the quarter. Comp traffic was a variety items. Greg talked about the lawn and garden performance with the attachment rates. Our commercial business was up actually a little better than the company average. I think it's a little early to suggest that housing has a material impact on our business. We certainly think as we get into 2013 and housing recovery continues to gain traction, we'll start to see more of that benefit as we move forward. I think it's a little premature to see that show up in our numbers at this point.
Were there vast geographic differences on your overall comp performance?
Not too wide. A very narrow band relative to what we've seen a number of years ago.
Okay. My last question is on the guidance. I believe you lowered your EBIT margin expectation for the quarter, for the year. Can you talk about what made that change?
Yep. We got off GAAP. We had some non-operating charges in Q3. Those impacted our EBIT outlook for the year.
Nothing changed about the fourth quarter, correct?
Correct.
Thank you very much. Good luck with the end of the year.
Thank you. Regina, I think we got time for one more question.
Your final question will come from the line of Matthew Fassler with Goldman Sachs.
Greg, good morning. Thank you very much. Two questions. First of all, maybe cutting it a bit finely here, your quarter ended a week than it perhaps otherwise might have, given the shift in the 53rd week last year. You had, I guess, Sandy prep sales that fell into, I guess, the traditional retail fiscal quarter, and then you had four or five days that encompassed the storm and its immediate aftermath. Of the 60 basis points or so, the 30 basis points or so associated with Sandy, was most of that before or after, if you have a way of cutting at that finely?
This is Robert. Matt, I would say, most of that would be before, because if you think about the storm hit on a Monday night, okay? Monday night, our quarter ended on that Friday, four days after the storm. You got to consider that starting on Monday, you start having store closures. You had, as Greg said in his comments, over 140 stores that had their operating hours impacted to some extent. By the end of that week, we'd gotten all the stores back open except for the Rosedale, New York store that I spoke about that opened last Wednesday. It was closed for a couple of weeks. Yeah, more of it would have been preparatory because you had a lot of stores' operating hours closed, then, of course, by Friday, it was the end of the quarter.
Got it. Thank you. My follow-up, we haven't talked about the MyLowe's portal today. Obviously, a lot seems to be going right on the merchandising side. If you think about that online effort, can you talk about sign-ups, and can you talk about whether you're seeing commercial impact emanate from the connections you're making with customers through that portal?
Yeah, I'll start, and then I'll turn it over to Greg. Our activations now, unique swipes are up to about 14 and a half million. We've got over four million registered users, continuing to see a great response to MyLowe's. One of the key items that is used, which is a tremendous benefit for customers, is the purchase history of whether they're buying in-store or online, no matter what channel. If they've got everything out and registered, all of those sales, they have the history of that out there. It's a convenient way for them to be able to manage everything about their home. We're seeing great response. Greg, did you have-
Yeah. Rob, I just would mention that, Matt, we're up to about almost 400,000 items on Lowes.com. The acquisition of ATG has really helped us accelerate the addition of critical relevant items to that experience. We're finding that one out of four customers in some way through their shop and purchase process is in contact with .com in one of those phases. The addition of flexible fulfillment has helped quite a bit, and we're seeing the .com revenue, the penetration is exceeding expectations right now. I would say that there's in a large part helped by the MyLowe's, which really is a loyalty program in a sense, without points, and flexible fulfillment, which is giving customers what I think are relevant options to make sure that they can get the product where they want and how they want it.
Gentlemen, if you profile the customers who swipe MyLowe's and their behavior before they hooked up with the program, if you were able to track it versus after that, or perhaps just the general characteristics of the customer who's availed themselves of the program, any change in their behavior during the time that they've adopted or hooked up with the program?
Yeah, Matt, they spend more overall, and they continue to transact more often, and they spend more transactions than those customers that aren't in the program. Those trends continue.
Thank you.
As always, thanks for your continued interest in Lowe's. We look forward to speaking with you again when we report our fourth quarter 2012 results on February 25th. Have a great day.
Ladies and gentlemen, this does conclude today's call. Thank you all for joining, and you may now disconnect.