Lowe's Companies, Inc.

Good morning everyone and welcome to Lowe's Company's first quarter 2019 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 and the company can give no assurance that they will prove to be correct. Those risks are described in the company's earnings release and in its filings with the Securities and Exchange Commission. Hosting today's conference will be Mr. Marvin Ellison, President and Chief Executive Officer, Mr. Bill Bolts, 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. Our first quarter comp performance is a clear indication that our focus on retail fundamentals is gaining traction. Despite solid top-line results, our gross margin performance in Q1 highlights that we still have work to do as we continue our transformation. We're taking the necessary short and long-term actions to improve our gross margins, which I'll discuss in more detail in a moment. But first, let me highlight what drove our sales performance in Q1, specifically our commitment to improving in-stock and customer service, coupled with our focus on winning the Pro or KeyStar improved sales performance. For Q1, we delivered total company comps of 3.5%, and our U.S. home improvement comps grew .2% for the quarter. Weather was challenging early in the quarter, given that we experienced the second-weather February on record. In fact, unfavorable weather exerted 315 basis points of top-line pressure in February. As weather improved, we saw a broad-based sequential improvement with comps of a negative .4% in February, positive .5% in March, and positive .2% in April. We drove increased traffic to stores and to Lowe's.com and generated a more balanced top-line growth with increasing transactions by .2% and increasing average ticket by 1.3%. We delivered positive comps in 10 of 13 merchandising departments, including double-digit comps and seasonal and outdoor living, and high single-digit comps in Lawn and Garden. We drove positive comps in all geographic regions, with the exception of Tampa and Houston, which faced tough prior year comparisons from hurricanes Irma and Harvey. For Q1, some of our best performing geographic regions were Atlanta, Charlotte, Los Angeles, Nashville, New York Metro, Pittsburgh, Philadelphia, and Richmond. Our pro comps significantly outperformed DIY, and we see early evidence that our strategic initiatives with this very important customer are gaining traction. Joe McFarland will add additional color to our pro performers later in the call. For Lowe's.com, we posted comp growth of 16% for the quarter. Although we're still not where we'd like to be with our online business, I'm pleased with the progress our new leaders are making to improve the infrastructure of this very important channel. In Canada, we posted negative comps for the quarter as a weaker Canadian housing market exerted pressure on the business. Adjusted diluted earnings per share were $1.22 for the quarter, and a convergence of factors led to gross margin pressure in the quarter. Some of these challenges are a reflection of the tools and process limitations I've discussed on previous calls. But what's important is that we have our arms around the issues and have plans to improve gross margin over the course of the year. Allow me to take a moment to outline the factors that led to our Q1 gross margin shortfall. First, we recognize inventory first in first out. So cost increases that were agreed to by merchants in 2018 are now flowing through the P&L as we turn inventory. The majority of these costs increases that were accepted in 2018 without any corresponding offset to gross margin pressure. Second, as we are preparing and we're preparing for the business season of the year, we undertook unprecedented levels of change in our merchandising organization. Over the past six months, we've replaced two of our three merchandising senior vice presidents and we replaced 11 of our 13 merchandising vice presidents. This level of change was necessary to ensure that we have the best talent in position to for the second half of the year, spring of 2020, and to fuel our future growth. However, as we transition from legacy merchants to new merchants, there was much more disruption in Q1 than we anticipated. This disruption was primarily driven by a lack of visibility in our pricing ecosystem. Our new merchants simply did not have clear line of sight to the cost increases that were accepted by prior merchants as we transitioned. Based on the really limited systems visibility, we could not quickly analyze and offset these cost increases with appropriate pricing action. Our challenges with pricing tools and processes aren't new to Lowe's. However, we did not anticipate the impact of poorly communicated cost increases, significant organization changes with 11 new merchandising VPs, and legacy ineffective pricing tools and processes. Now let me take a moment and outline the decisive actions we're taking to improve our gross margin for the balance of 2019. First, our CIO, Samantha Lee, is leading an effort to implement changes to our pricing and point of sale systems. With these changes, we will streamline who can affect cost and pricing changes and sequence those pricing actions to prioritize those that have the greatest impact to gross margin. We'll also have better visibility for the merchants to understand the impact of all pricing actions without having to view multiple systems and numerous reports. We're establishing a more efficient process to systemically analyze, prioritize, and implement pricing actions to offset cost pressure. Second, our recent acquisition of Boomerang's retail analytics platform, a leading pricing analytics practice, is a significant step forward towards modernizing our approach to pricing. By digitizing our business processes and increasing our agility. This acquisition reflects our commitment to modernizing our systems and reinforces our philosophy to buy versus build capabilities if that approach is more advantageous for the company. And finally, as our merchant leaders accrue more time in their roles, they have better view of their categories and assortment plans. And stability in any organization is important, and now we have that stability for the balance of 2019 in our merchandising organization. With enhanced visibility, the merchants are better able to offset cost pressure with adjusting prices within their portfolio products. In addition, we're building improved pricing analytics to help offset future cost pressure and protect gross margin to impact the top line sales. It's important to mention that we believe our pricing issues hurt top line sales as well as gross margin in Q1. By not taking pricing action on our intellect excuse to offset cost increases, we simply decremented top and bottom line at point of sale, which we believe negatively impacted sales. As I've discussed on previous calls, this is a multi-year transformation, and we're in phase one of a three-phase process. However, our first quarter results clearly reflect two things. First, our .2% comp in the U.S. clearly illustrates that customers are responding to our changes and our approach to retail fundamentals is working. From my experience, there are three things you hope to see during the early stages of a transformation. You want to see positive customer transactions, you want to grow average ticket, while reducing expense and improving efficiencies to leverage SG&A. We saw all three in Q1, which gives us confidence that we're taking the right strategic steps. Our first quarter also reflects that as we encounter systems and process limitations during this transformation, we now have the experience and the internal expertise to address the issues and minimize the impact on future periods. The issues that impacted low gross margin in Q1 have been identified and are being addressed with process changes and system adjustments. Consequently, we expect to deliver improved gross margin performance over the balance of the year. We made a lot of progress, but our transformation is clearly ongoing. Our first quarter comp and our improved sales floor productivity, driven in large part by the pro customer, gives us confidence that our strategy is working. And we're committed to making the investments and taking the actions necessary to address legacy issues and position loads for sustainable long-term sales and profit growth. My most enjoyable time as CEO is the weekly business I spend in the stores. Our associates have demonstrated to me their passion for our customer and for this great company. So before I close, I'd like to thank them for their hard work and their commitment to serving the customers and serving their communities. And with that, I'll turn the call over to Bill.

Thanks, Marvin, and good morning, everyone. As Marvin shared with you, we capitalized on spring demand in the first quarter, posting U.S. comparable sales growth of 4.2%. We transitioned into the spring season more efficiently. We began setting our stores from south to north three weeks earlier than last year. And we adjusted our store inventory load in to 60% versus 35% last year. These actions ensured that we were ready for the spring season and positioned us to have adequate seasonal inventory on hand to capture that spring demand. Our teams also significantly improved sales floor productivity through better use of home caps and a redefined strategy for off-shelf side stacks. We leveraged our spring Black Friday event to take advantage of seasonal project demand with strong messaging and attractive offers, more personalized marketing, and a continued shift into digital and localized marketing channels. And as Joe will share with you in a moment, our associates delivered very well in the aisles and executed a very successful event. Our success in driving strong spring sales was supported by the improved service model in our stores and a better in-stock execution. For the quarter, we achieved double-digit comps in seasonal and outdoor living, led by double-digit comps in outdoor power equipment, where we continue to leverage the top three brands in writing equipment with John Deere, Husqvarna, and Craftsman. We also drove double-digit comps in grills through our offers from Weber and Charbroil, the top two brands in outdoor grilling. In addition to seasonal and outdoor living, we also delivered high single-digit comps in lawn and garden with the strength in our lawn care and landscape products through the power of the Scotts brand and in live goods with our nationwide Bonnie plan offers along with the extension of our Monrovia plan program, a home center exclusive. In the first quarter, we also saw strength in our tools and our appliance businesses. We have posted above average comps and tools as the Craftsman reset continues to drive strength in categories like tool storage and mechanics tools. We're excited to be able to complete the Craftsman tools reset by the end of the second quarter and we look forward to introducing the brand into additional categories in the second half of the year. The Craftsman brand along with our proprietary Cobalt brand continues to drive traffic and they both create a loyalty building opportunity for us. We are proud to be able to offer both brands and to be the exclusive destination in the home center channel for the Craftsman brand. We also drove above average comps and appliances as we continue to leverage our leading market share position through our top brands, our breadth of assortment and our strong events. Though paint performed below the company average, the category still delivered positive comps even with the significant weather pressure early in the quarter. Our intense focus on our retail fundamentals while leveraging our exclusive partnership with Sherwin Williams has allowed us to continue to drive progress in this category. As Marvin indicated, we are in the early stages of implementing change which did create some disruption in Q1. However, I'm very pleased with the talent and the deep retail experience we've been able to recruit and to infuse throughout our merchandising organization. Our new leaders are now firmly established in their roles and we expect this leadership stability to drive sustainable improvement for the balance of 2019 and beyond. We are encouraged by the early results that we are seeing from our new merchandising service team. These teams are supported by our vendors and they are responsible for the day to day bay maintenance and resets in our stores along with setting and maintaining end caps and help executing off-shelf displays. The MST teams are a critical component to improving our merchandising reset execution at store level as they take these important and time consuming tasks off the shoulders of our Red Vest associates so that they can be freed up to serve our customers. The early results of our MST program show reductions in out of stocks, an improved sales productivity and an increase in base service per hour. The MST has also provided critical support during our successful Spring Black Friday event as well as for our Craftsman outdoor power equipment and tools reset. As Marvin stated, we were very pleased with our pro business in Q1 and we are focused on leveraged our improved in stock position along with our key brands to drive additional sales with this very important customer. As an example, in the first quarter we announced that Little Giant Ladder Systems, a leader in safety and innovation, has chosen Lowe's as their exclusive home center partner. Our teams continue to work to add more key pro brands to our assortments as well as leveraging our existing partnerships with brands such as DeWalt, the number one power tool brand in the industry and the new and innovative products we have from Bosch and Metabo HPT that are all focused on saving the pro both time and money. In the first quarter, we also took steps to driving merchandising productivity and localization through the investment and rollout of our field merchandising teams. The teams are now in place and we expect to see the continued benefits from their work with our merchants and our stores in the second half of 2019. As we look ahead to Q2, we remain focused on carrying our momentum forward. We expect to drive sales and traffic with our compelling Memorial Day, Father's Day and July 4th events. The power of Craftsman as we complete the rollout of our Craftsman tool program and our pro categories as we continue to capitalize on our job lot, quantity investments and our focus on this very important customer segment. We also remain focused on driving improved growth on Lowe's.com as we work to increase our online assortments, continue to improve the shopping experience and work to shift slower moving skews out of our stores and onto our website to improve inventory productivity. We're excited about the opportunities that are ahead of us and we're working very hard to position Lowe's for the future and to capitalize on a strong demand in a healthy sector. Thank you and I'll now turn the call over to Joe.

Joe Thank you Bill and good morning everyone. As Marvin indicated, our commitment to improving in stocks and customer service along with our focus on winning the pro were keys to our improved sales performance in the first quarter. To improve associate engagement, we rolled out the SMART model, a new customer service model which guides the way we hire, train, evaluate and coach our associates. This program models what a great experience actually looks like and drives behaviors that deliver the kind of experience that customers want. It includes a comprehensive toolkit, training program and mobile devices which are designed to provide our associates with the tools they need to deliver outstanding customer service. In the first quarter alone, we trained over 280,000 associates on SMART customer service and we also rolled out approximately 88,000 SMART mobile devices to our stores. Associates are no longer required to leave the sales floor to log into a terminal to determine the price, availability or order status of an item. The new SMART device reduced tasking hours by providing associates with real-time data without ever stepping off the sales floor. For example, the SMART devices have functionality and process by online pick up and store orders. This new functionality takes us from a 12-step paper-based process to an average of two digital scans. In the first quarter, 60% of our online purchases were picked up in our stores which reinforces the power of our omni-channel model. The role of SMART devices in the systematic improvements in buy online pick up and store represents a significant advancement in the partnership between our stores and IT and are really terrific early examples of what we can accomplish as an organization when we are focused and aligned. To further improve the customer experience, in the first quarter we replaced a series of non-facing customer positions with over 6,000 assistant store managers and department supervisors. These customer-facing store leadership roles are focused on providing better departmental coverage and expertise as well as coaching our associates in delivering excellent service. Previously, for example, a single department supervisor was tasked with covering the lawn and garden, rough plumbing and electrical, and paint departments simultaneously, which simply isn't manageable. With the addition of department supervisors, we are ensuring that we have the proper coverage for strategic areas of focus such as paint. To that end, one of the incremental supervisors is dedicated to the Pro department. As we have discussed before, the Pro customer is a key focus for us in 2019. In the first quarter, we were very pleased with our sales and customer service improvements in Pro. This improvement was driven by executing five key steps. First, we addressed our -of-stock issues and poor inventory presentation with a commitment to improving our job-lock quantities and our product presentation under the Pro canopy and on our end caps. Second, we improved our store-level service to ensure we can get our Pro customers in and out faster. This included adding dedicated loaders and establishing preferred parking under the canopy. Remember, for the Pros, time is money. Next, we staffed our Pro desk with dedicated associates, working a consistent schedule, and we added department supervisors to all Pro areas of our store. We redesigned our field structure, adding 15 new regional Pro managers, and recruited experienced leaders to focus on our in-store and outside Pro sales. Finally, we worked with Bill and the merchandising team to communicate a consistent volume pricing message and improved our product presentation in the area. After we felt comfortable with the execution of these five steps, we invited customers in to see our improved environment with a very successful and nationally marketed Pro appreciation event, which allowed us to grow our Pro accounts. In fact, we opened over 40,000 new Pro accounts in the first quarter. We also leveraged our exclusive partnership with the NFL. We ran Pro-focused national advertising during the NFL draft. This was an extension of our Do It Right for Less campaign, reinforcing that Lowe's offers the job site delivery and job lock quantities Pros need, as well as designated Pro supervisors equipped to help our customers. Although we are pleased that our first quarter Pro comps significantly outperformed our DIY comp, we are still in the early stages of our transformation with this customer. I look forward to discussing additional initiatives for the Pro and upcoming calls. In closing, to improve staffing and better leverage our payroll spend, in the second quarter, we'll continue the rollout of our new customer-centric labor scheduling system. This system will better predict customer demand by time of day, day of week, and department, allowing us to align our labor hours with peak traffic, providing better department coverage and customer service, while ensuring that we're using our labor hours efficiently and reducing our overall payroll expense. This new system will replace our current staffing system that doesn't effectively capture and predict sales and customer traffic patterns. We'll have this new system fully rolled out in the second half of this year. Though we are in the beginning stages of change, we are excited about the early results we're seeing and committed to the work ahead to fully capitalize on the healthy demand in our sector. Thank you, and I will now turn the call over to Dave.

Thanks, Joe, and good morning, everyone. Let me begin this morning with just a few housekeeping notes. First, as disclosed in our press release, this quarter we adopted the new lease accounting standard using a prospective transition approach. The adoption of the standard resulted in an increase in lease-related assets of $3.6 billion and an increase in lease-related liabilities of $3.9 billion. The difference between the increases in lease-related assets and liabilities net of the deferred tax impact was recorded as an adjustment to beginning retained earnings. The standard had no impact on our debt covenant compliance under our current agreements. Second, as also described in our press release, in the first quarter we realized a tax benefit in connection with our previously announced decision to exit our Mexico operations. We had originally planned to sell the operating business. However, in the first quarter, after an extensive market evaluation, we decided to instead sell the assets of this business. That decision resulted in an $82 million tax benefit, which all set $12 million of pre-tax operating costs for the Mexico operations within the quarter. With that, I'll turn to a review of our operating performance, starting with our capital allocation program. In the first quarter, we generated over $1.9 billion in free cash. And through a combination of both dividends and share repurchases, we've returned over 60% of this cash to our shareholders. In the first quarter alone, we paid $385 million in dividends, and our dividend payout ratio currently stands at 37%. We also entered into a $350 million accelerated share repurchase agreement, retiring approximately 3.2 million shares. And we purchased approximately 4.4 million shares for $468 million through the open market. So in total, we've repurchased $818 million of our stock at an average price of $107.60. We have approximately $13.1 billion remaining on our share repurchase authorization. In April, we issued $3 billion of unsecured bonds. The issuance consisted of 10 and 30-year notes with a weighted average interest rate of 4.1%. The proceeds of this issuance were used to refinance current year maturities and other general corporate purposes. And we continue to invest in our core business with capital expenditures of approximately $205 million in the first quarter. Now, looking at the income statement, we generated gap diluted earnings per share of $1.31 per share compared to $1.19 in the first quarter of last year, an increase of 10.1%. On a comparable basis, excluding the $82 million tax benefit and $12 million of pre-tax operating costs from Mexico, adjusted diluting the earnings per share was $1.22, an increase of .5% compared to L.Y. As Marvin indicated, though we are very pleased with our sales performance, we experienced significant gross margin contraction, which resulted in lower than expected earnings per share in the quarter, which I'll discuss in more detail in just a moment. Sales for the first quarter increased .2% to $17.7 billion, supported by total average ticket growth of .9% to $77.19, partially offset by a slight decline in total transactions. Comp sales were 3.5%, driven by a comp transaction increase of .2% and an average ticket increase of 1.3%. Our U.S. comps was .2% for Q1. So looking at monthly trends, the total comps were negative .4% in February, positive .5% in March, and positive .2% in April. Additionally, monthly comps for our U.S. business were negative .9% in February, a positive 4% in March, and a positive 8% in April. Now if you were to adjust for the impact of commodity deflation along with weather in February, our U.S. comps would have been approximately .7% for the quarter. Gross margin in the first quarter was .5% of sales, a decrease of 165 basis points compared to Q1 of last year. We experienced approximately 90 basis points of pressure from the challenges with our pricing ecosystem that Marvin discussed earlier. The tools and process issues have been identified and are being addressed to mitigate this pressure going forward. As expected, we also experienced approximately 40 basis points of pressure from supply chain costs as we added new facilities to the network that are still ramping up to full capacity, coupled with ongoing increases in transportation costs and customer deliveries. Product mixed shift had approximately 30 basis points of negative impact on gross margins also in the quarter. SGMA for Q1 was .8% of sales, which levered 89 basis points. We drove 80 basis points of leverage in retail operating salaries and 17 basis points of leverage through improved advertising efficiency. We also had 34 basis points of leverage from lease assignments and terminations associated with last year's store closing activities. These items were partially offset by the leverage in incentive compensation and employee insurance. Operating income decreased 45 basis points to .99% of sales. The effective tax rate was .6% compared to .3% last year. This significant improvement year over year is primarily due to the favorable tax benefit associated with the change in approach to exiting our Mexico operations. On a comparable basis, our adjusted effective tax rate was 22.9%. At $15 billion, inventory increased $1.8 billion or .8% versus the first quarter of L.I. This is largely driven by inventory to support anticipated seasonal demand, adjusted presentation minimums, and investments in job lock quantities. Albeit a significant increase in inventory, these are important strategic investments to drive sales performance in the coming months. Now before I close, let me address our 2019 business outlook, which has been updated to reflect our gross margin miss to plan in the first quarter and to adjust the remainder of the year for the expected timing and impact of our corrective actions. For 2019, we still expect a total sales increase of approximately 2% for the year driven by a comp sales increase of approximately 3%. However, we now expect adjusted operating margin to increase 20 to 50 basis points. The effective tax rate is expected to be approximately 24%. And so we now expect adjusted diluted earnings per share of $5.45 to $5.65. We are now forecasting operating cash flow of approximately $4.5 billion as a result of our lower operating margin expectations and an increase in inventory versus our plan. CAPEX is still expected to be approximately $1.6 billion and this is expected to result in free cash flow of approximately $3 billion for 2019. Our target leverage ratio remains at 2.75 times. So with that, our guidance now assumes approximately $4 billion in share of purchases for the year. Now as Marvin mentioned, we're early in our transformation, but we now have management team in place with the expertise required to tackle the opportunities ahead of us. With the sales momentum we gained throughout the first quarter, we remain extremely excited about the future of our business and are focused on taking the necessary actions to both improve our performance and drive long-term shareholder value. And with that, we're now ready to take questions.

We are now ready for questions. To ask a question, press star 1 on your telephone keypad. To withdraw your question, press the pound 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 Baker with Deutsche Bank. Michael, you may be on mute. Our next question will come from the line of Scott Mushkin with Wolf Research.

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

I'll take the first part of that. It was primarily unexpected. As I mentioned, we see our inventory first in, first out, and we had cost increases that were taken in 2018 with no offsetting steps to protect the gross margin, which obviously was not a great decision. Because of the limitations within our system and the transition of our merchandising team, we literally had no visibility to those cost increases until the inventory that was increasing cost started to hit the P&L as it layered and sold through with inventory returns. Our legacy systems really gave our merchants and our finance team limited visibility to these changes until it literally hit the P&L. We did not have an expectation this was going to happen. The good news is that we've upgraded our systems to provide better visibility to the cost and retail pricing actions. We now have the ability to prioritize which pricing actions to take. As Dave mentioned, we've taken mitigative steps and actions to address this. Where we have made the changes from pricing actions, we feel good about the -over-year performance in our gross margin. We're just continuing to work through the issue. Again, it was not something we planned coming into the quarter.

Thanks for that, Marmina. Then just one follow-up for Dave. It looks like the six times rent calculation that you had in your leverage ratio target prior to this new standard was understating the operating lease adjustment, which is now actually on the balance sheet. Given you ended one queue with the leverage so close to your target, are you foreseeing any modification of the target going forward? Some wiggle room in your capital allocation strategy for the year?

Sid, I think if you look at that number, it changed only modestly. I think our estimates were pretty spot on from that perspective. We do not anticipate changing our cap structure 2.75 times based on that adjustment.

Thank you.

You're welcome.

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

Thanks. Good morning, guys. Just to clarify, this GM weakness, this was not driven by promotions. This was bad systems. There was some execution. By the logic you provided on the call where you didn't get higher prices on inelastic items, you didn't mention elastic goods because by that logic, if you didn't push higher prices on elastic goods, why is that different from being promotional or even discounting?

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

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

So I'll take the first part of that and now that Dave can provide any additional context. So as I discussed and Dave mentioned, this is worth about 90 basis points. And again due to the limited system's visibility, we didn't know this was happening so we started hitting the P&L. To be really doing the same thing as we did last year. We're just doing the same thing as we did 40 or 50 weeks ago. And without any mitigating actions I mentioned to offset gross margin. So as we work through making the pricing adjustments where we have implemented pricing action, the gross margin is the same as we did last year. And we're taking additional strategic pricing actions as we analyze the full impact of 2019. We're confident it's working. We simply are taking the time to analyze the results to make sure that we understand the full benefits of 2019. And because of that we felt it was prudent to update the guidance because this is an ongoing effort. So that's the operational execution side of it. And the good news is the partnership between finance, merchandising led by IT, we have significantly better visibility to all pricing actions, to cost increases. We have now one team responsible for approving and managing all costs and retail increases. We also have a very basic retail philosophy and that is if you accept a gross margin, that's not unique in retail but it was unique to Lowe's until Q1. So we now have our arms around this and that's the operational execution side of it. Now let Dave speak to any of the accounting side.

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

Okay thank you.

You're welcome.

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

Good morning thanks a lot for taking my question. Can you give us more specifics on what categories the price increases that you experienced are in and why can you not remediate or address this issue until the second half of the year? Why can't you just take the price increases on those inelastic goods right now?

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

Yeah I think just a couple of things to add. When you start to take it on and when it's across the number of categories it's across it's what I refer to as real pick and shovel work and so it's a skew by skew review. You have to look at it at the assortment level as well so that you don't screw up the assortment philosophy of what a merchant's trying to do. So all of that is being done and as both David and Marvin have mentioned where we have been able to do some of that in the last few weeks we have seen improvement happen. In addition to that as I've shared with you on the other calls we're in the early stages of rolling out category management into the organization. So you want to be able to do this in conjunction with the category management philosophy where you've got the intent of each of these product categories so that the philosophy falls into and then it can be built into financial planning as you move into 2020. So we're rolling into that second phase of category management in the back half of the year. We start to apply it into each one of these product categories. You take this work you've got to roll it in together so that we don't do something stupid so that's what we're working on. And

Mike I think it's worth me noting that you know we're looking at this short, medium, and long term. So short term we've improved visibility for the merchants on all pricing actions. We've eliminated the need to look at numerous systems, multiple reports to get basic pricing and cost information. We now have one team in place to manage cost and price. We now have the ability to prioritize which pricing actions we take that have the greatest impact on gross margin. Believe it or not in Q1 we couldn't do that. We have a really simple philosophy that's pretty consistent in retail and that is if you take a cost increase for any reason you got to offset that within the portfolio with actions to protect gross margin. All these things sound basic but these things didn't exist in Q1. So that's short term. By Q4 Samanth and our chief information officer is implementing a new price management system. It's going to be rolling out. It's cloud based, it's agile, it's going to enhance the visibility for the entire merchant and finance team on pricing. It's going to be a single repository for pricing for lows, something we currently don't have and that's going to that is being developed as we speak. This will get us to parity. Then the acquisition of Boomerang's retail analytics platform in 2020 we're going to integrate that to this new price management system. This is going to give us a best in class system for both price intelligence and price management. This is another example that this is a multi-year transformation. So we've got short term actions we're taking right now. We've got actions later this year that's going to get us to parity with a pricing management system and in 2020 we believe with the acquisition of Boomerang's retail analytics platform we're going to have a best in class pricing system and that's the cadence that will follow.

That's helpful. Two more quick questions. Given that this surprised you, do you think Marvin that you might have underestimated some of the depths of the challenges that the business is under and as a result it's either going to take longer to achieve the longer term margin expectations that you set or excuse me the longer term margin expectations might be difficult to achieve and then on the quarter your sales performance had improved how much of the incremental inventory that you added contributed to the better sales performance?

So Michael it's a fair question. We still feel good about the outlook we gave at the Anilson Investor Conference this past December. There's a lot of work to do and my team knows that one of my favorite comments is that all the easy jobs are done by the company that's been working for us for the last year and we're not going to let that go to waste. We're going to let the company that's been working for us fail. So when we came here to take this on we knew we were working for a great company with an outstanding balance sheet but a company that had underperformed its sector for a significant amount of time. If Q1 proved anything it proved that this team can drive sales and so we're pleased with our results. We think it's about getting in stock, about the investment in job life quantities, about the improvements in customer service, about the space productivity that the MST team is helping to drive and the focus that Joe talked about in PRO. We're in the early stages with PRO. We understand that there are other things that we will do. We have a great platform in MSH that we're going to be talking about later this year. We have some initiatives we're working on with same day job site delivery. We've got this wonderful unique pilot with FedEx on the same day delivery bot that is going to change and revolutionize how you get product to PRO customers and so we have a long-term view but we're just really pleased that the fundamentals that we put in place for our business are paying dividends in Q1 and we think that's going to continue for the balance of the year. We simply have to get our arms around these issues and the last point I'll make is are we going to have surprises? I'm sure we will but when I look around the table at the men and women that are on this leadership team we have people who have the experience, the talent and the expertise to solve these issues and as devastating as the margin impact was in Q1 with these unanticipated fully thought out cost increases the team rallied, got our arms around it and we're going to be able to resolve this as the year progresses.

Thank you very much.

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

Hey good morning. So online sales up 16 percent, nice acceleration versus late 2018. Curious if you could speak to some of the drivers here, anything new you're doing with respect to the website or online ads, any category call outs and then second part as your online sales accelerate could you speak to the margin impact and any thoughts on mitigating the fulfillment drag there?

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

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

Got it and then one for David on the change in EBIT outlook. Just want to confirm that the 50-60 basis point change or so entirely at the gross margin line and then whether you expect the impacts to be felt throughout the year or if this is more concentrated in you know the 1Q2 with improvement in the back half.

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

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

Yeah we don't really guide to that level of specificity.

Got it appreciate the time guys. You're welcome.

Your next question comes from the line of Christopher Horvors with JP Morgan.

Thanks good morning. Can you talk a little bit about your business outside of seasonal? Obviously did a lot of work to front-mode inventory, improve processes and drive in stocks. Can you talk about the improvement in the rest of the business particularly as we look into the back half of the year? The seasonal really fades. How are you thinking about the improvement that you're seeing in the back half and then you know more broadly you know tough compare here in 2Q, easier compare in the back half. How are you thinking about cadence especially in light of your comments that you should be able to accelerate demand because you didn't capture price and elasticity?

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

Great thanks Marvin. So as Marvin mentioned we're very pleased with the acceleration of the Pro business throughout the entire quarter and as we mentioned phase one was really the retail fundamentals and we've really got our arms around the retail fundamentals in Pro. I mentioned in my comparative remarks the supervisor, the dedicated staffing, the loaders, the job lock quantities and so as you think about that we continue to see acceleration into Q2 in this Pro business and feeling that we now have a foundation in place that we have basics for the Pro done as we accelerate that through the back half of the year with things like Pro loyalty you know things that will help us capture a much larger share of the Pro's wallet you'll see that come to life you know through brands through advertising and through service in the store so we remain very very pleased with the Pro. I also

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

We're going to take one more question please.

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

Hi good morning thank you for taking my questions. So I apologize this first one's a bit repetitive but more of it I just want to go back you know and look at the release day in your comments you know you had the 4.2 percent domestic comp a nice improving trajectory through the quarter you laid out you know in the prepared comments that that would have been markedly higher had it not been for for weather and then we had the issue on on gross margin with the corrective actions you take. Am I hearing you correct that those really are distinct events you know meaning that the corrective actions that impacted gross margins did not contribute to the to the to the to the sales showing in the quarter?

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

got it's helpful and then a follow-up quick follow-up i had in the the monthly comp cadence you gave us you the domestic comp in the month of april was eight percent recognizing it's early here in fiscal q2 but any commentary how sales attract here into into may or into q2

well what i would say is that they're as expected we have some big events including this weekend coming up we feel like our in stock position is as good as it's ever been we feel like our staffing levels are as good as they have ever been and we feel like that our stores are set and we are assigned and we are marketing for success as frustrated as we are by the gross margin performance and the poor decisions made and the limited system visibility on cost increases we're correcting that but we want to be crystal clear that we are aggressively going after sales and and we believe that the success that we have in q1 will carry over into the balance of the year because it was driven by in stock improvement service improvement improved space productivity and driving the pro sales and we think we can maintain that in q2 and for the balance of the year

let me if i could just ask one more kind of a bigger open-ended question but given

the

comments here about you know identifying this is this inventory flow issue i'm just going to inventory flow issue i mean has that we're being surprised by it has that allowed you to now look elsewhere for other potential surprises if that makes sense i mean this issue popped up could your team now say well this is you popped up something else might pop up we're looking into that

the the short answer is yes we have taken aggressive steps let me rephrase that more aggressive steps to make sure we analyze review and do systemic reviews of every single thing we can imagine so not to have another unexpected event like we experienced in q1 and we're going to continue to be laser focused on that and the good news is we have people around the table with deep experience and deep expertise the good news is we changed a lot of merchants which was disruptive we accept that we did it on purpose because we wanted to have the right merchant leaders sitting in position through spring of 19 so they could have us plot our strategy for fall for spring of 2020 and beyond and we have merchants with deep experience we've got merchants with 30 40 years of category experience now sitting in these vice president's roles and so they are helping us identify additional issues but they have the skill set to solve them and we now have the technical expertise in house to get the right systemic solutions and so yes we're doubling our efforts making sure that we limit the number of surprises that will get us in the future

thanks for all the color appreciate it thank you

ladies and gentlemen this will conclude today's call thank you all for joining and you may now disconnect