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Operator
Good day, everyone, and welcome to today's Home Depot first quarter earnings conference call.
As a reminder, today's call is being recorded.
Beginning today's discussion is Ms.
Diane Dayhoff, Senior Vice President of Investor Relations.
Please go ahead.
Diane Dayhoff - SVP IR
Thank you, Kenda, and good morning to everyone.
Welcome to the Home Depot first quarter earnings conference call.
Joining us on our call today are Frank Blake, Chairman and CEO of the Home Depot; Craig Menear, Executive Vice President, Merchandising; Paul Raines, Executive Vice President, U.S.
Stores; and Carol Tome, Chief Financial Officer, and Executive Vice President of Corporate Services.
Following our prepared remarks, the call will be opened for analysts' questions.
Questions will be limited to analysts and investors and as a reminder we would appreciate it if the participants would limit themselves to one question with one follow-up please.
This conference call is being broadcast realtime on the internet at HomeDepot.com with links on both our home page and the Investor Relations section.
The replay will also be available on our site.
If we are unable to get to your question during the call, please call our Investor Relations department at 770-384-2387.
Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1955.
These statements are subject to risks and uncertainties.
These risks and uncertainties include but are not limited to those factors identified in the release and in our filings with the Securities and Exchange Commission.
Now let me turn the call over to Frank Blake.
Frank Blake - Chairman, CEO
Thank you, Diane, and good morning, everyone.
This was a difficult first quarter for us.
Consolidated sales were $21.6 billion, up about 1%, but diluted earnings per share were down 24% at $0.53.
Our retail business had a negative comp of 7.6% for the quarter.
While we expected a tough quarter, this was worse than we anticipated.
There were a number of factors that contributed to our poor performance.
The housing and home improvement markets were soft and especially so in some of our traditionally strong markets in Florida and the Northeast.
The weather was challenging as we had one of the coldest Aprils in more than a decade.
Finally, we continue to work through our own issues on performance and execution.
Let me give you a summary assessment of what has gone well in this first quarter and where some of our major opportunities and issues remain.
First, our associates have responded quickly and enthusiastically to the basic message that we are focusing on our retail business and reconnecting with the core values that are the foundation of the company.
If anything, this has happened more rapidly than I anticipated, and is a testament to the strength of the culture of this company and how deep-seated it is in our associates.
As Paul will describe, we have taken a number of actions to change the way our associates are compensated, recognized, and rewarded to make it clear that taking care of our associates is one of the core values of the company.
We have also invested in associate hours on the store floor with a significant increase in payroll as a percent to sales.
With this, we have rededicated ourselves to excellence in customer service, and I hope you've seen some of that in our stores.
We remain committed to our strategy of investing in the retail business despite the challenging environment.
We know that this put additional pressure on our earnings in this quarter, but believe it was important for the long-term strength of our business.
Carol will take you through some of the specific drivers of the declines in our gross margin and operating profit performance.
As a point of reference, we saw comp transaction declines of 15% to 20%-plus in our northern division and in parts of our southern division during two key weeks in April.
It is difficult to make a timely adjustment for that level of decline.
We did, however, see positive comp transactions of a similar magnitude this last week as spring arrived in the north.
We are making good progress on our programmatic maintenance efforts and are well on our way on planned projects such as restroom remodels, floor polishing, relamping, and lot striping.
Over 20% of our projects are in progress or complete.
We accelerated clearance markdowns in the quarter in support of merchandising reset activities.
We are revamping our processes for connecting with smaller vendors with innovative products who in the past have found it difficult to deal with some of our bureaucracy and procedures.
We have taken early steps forward in our supply chain transformation.
We have implemented enhancements to our replenishment systems, we successfully went live with our first distribution center conversion to the Manhattan Warehouse Management System, which will be our single state-of-the-art platform, and we have begun to pilot our new central distribution concepts.
We have also made significant improvements in the services we provide to our Pro customers, particularly through our bid room.
We have nearly tripled the volume of business that we do through our bid room.
We believe we have narrowed the gap between our performance and our market's performance, but we still have significant room to improve.
Craig will describe for you some of the areas where we are seeing market share gains as well as some of the areas where we continue to struggle.
We need to bring to every effort we undertake a consistent customer-based and store-based focus.
This may sound obvious, but there are worlds of differences between a program that briefs well in Atlanta and one that works well in the store.
We still have too many programs that aren't designed for effective implementation in our stores.
Now let me address our international retail business.
Our international businesses, Canada, Mexico, and China, performed well during the quarter.
Canada's comps were above the U.S.'s and the sales growth there was consistent with the Canadian home improvement market's growth.
Our Mexican stores continued to outperform the market, posting double-digit comps in the quarter.
And our China stores are performing consistent with our integration plan.
Leaving retail and turning now to our Supply business, sales were $3.1 billion, up 46% and operating profit was $163 million, up 9% for the quarter.
Like our retail business, Supply's results were impacted by the slowdown in the housing market during the quarter.
As a result, organic sales declined 6.5%.
We continue to analyze strategic alternatives for the Supply business.
We are working as diligently as possible on this and we will update you as soon as the review is complete.
For the quarter ahead and the remainder of the year, we expect the U.S.
home improvement market to remain challenging.
One simple benchmark that we've used is the percent of gross domestic product, GDP, represented by private residential investment.
This number was as high as 6.3% in late 2005.
It ended the first quarter of 2007 at 5%, the historic mean is around 4.8%.
Active mortgage equity withdrawals have declined significantly and housing inventory continues to build.
So we continue to see headwinds in our market and are not planning for any near-term market improvement.
We will, however, stay on strategy and invest in our five key priorities: associate engagement, product excitement, shopping environment, product availability, and own the Pro.
At the end of this call, Carol will give you an update on our earnings guidance.
Now let me turn the call over to Craig.
Craig?
Craig Menear - EVP - Merchandising
Thank you, Frank, and good morning, everybody.
Comps from the first quarter were disappointing and less than what we had planned.
Four departments performed above the company average: Electrical Lighting, Plumbing, Garden, and Appliances.
Two departments performed around the company average, Paint and Hardware.
Five departments were below the average: Lumber, Building Materials, Millwork, Flooring, and Kitchen and Bath.
As Frank mentioned, there were some notable factors in this quarter that impacted our performance.
Weather, commodity deflation, and tough housing market, particularly in certain regional areas where we have significant business.
This was partially offset by sharper focus on merchandising fundamentals and implementation.
We began the year in February with poor weather, but bounced back with in-line performance in March.
However, the first two weeks of April brought with it unusually cold, snowy, and wet weather that negatively impacted key Seasonal and Pro categories, particularly in the north.
These two weeks of April happen to be some of the largest run rate increase weeks in the quarter, so the timing of this weather impact was particularly difficult.
Falling lumber prices continued to negatively impact results.
In the first quarter, lumber price deflation negatively impacted comps by 95 basis points.
Lumber prices are at their lowest point in five years.
Existing and new home sales continued to be negative year over year, with some regions being affected more than others.
For example, we experienced double digit negative comps in south Florida and Boston due to slower sales and construction categories like windows and roofing.
Soft housing, along with the weather negatively impacted customer transactions.
Additionally, these conditions impacted our big ticket items, such as soft flooring and special order kitchens, consequently, the average ticket was down 2.9% from last year to $59.01.
Our gross margin rate in the first quarter reflects the acceleration of our merchandise strategies that we launched at the beginning of the year.
We cleared out products to make room for new merchandise as we launched our enhanced product line review process.
As an example, we accelerated the clearance in our wood and laminate categories as our stores implemented new resets in this area.
Additionally, our gross margin rate reflects an increase in sales penetration of lower margin items such as appliances, power equipment, water heaters, and wire.
Finally, with the current market environment and severe weather impact, we created three significant sales-driving events in an effort to support top-line sales in certain categories.
As part of our merchandise strategy, we told you that we would measure ourselves by our performance in market share improvement.
We are seeing positive improvement in many of our product categories, but we have a lot of work to do in others where we continue to lose share.
An example of where we are continuing to lose share is Bath.
To address this, we have begun to roll out Bath showrooms in new stores and smaller showroom resets in existing stores.
These design showrooms and resets improve product visibility, making it easier for our customers to shop.
Additionally, we are adding exciting new bath products under our Pegasus brand name to all of our stores.
Other underperforming categories will be addressed throughout the year as we keep on our merchandise strategy.
We have shared with you in the past that we have challenges in Flooring.
While we continue to work on soft flooring, we have seen improvement in hard surface flooring led by strong performance in wood flooring and ceramic truck tile, driven primarily by reset activity and new product assortments.
Both of these categories saw an increase in market share.
We did see market share improvement on a rolling 12-month basis in several additional categories as we implemented our focused bay approach in assortment, presentation, and value.
These included categories of Patio, Outdoor Power Equipment, Appliances, Nursery, Landscape, Power Tools and Accessories.
In Patio, we enhanced our offering to reflect the changing trends in outdoor living.
Customers also responded to the breadth of brand offering and the value in Power Tools and Outdoor Power Equipment.
Through our strong vendor partnerships, we have improved our execution, product quality, and value proposition in landscape and nursery products.
Finally, we will continue -- we continue to have success in appliances during the quarter, gaining share for the fourth quarter in a row.
I'm proud that we were once again named Energy Star retailer of the year.
This award was due in part to the Eco Options program that we launched in the fourth quarter last year.
We continued our success of this program in the first quarter.
Eco Options is intended to educate our customers on ways to be more energy efficient.
We gave away 1 million CFL bulbs on Earth Day and the additional sales of CFLs led to strong positive comps in lightbulbs.
Overall, customers responded positively to our 2500-plus environmentally friendly Eco Options products.
We will continue to work on enhancing this program with additional products to drive sales throughout the year.
As we look to the second quarter, despite the tough market, we believe our performance relative to the market will continue to improve as we proceed to execute our merchandise strategy.
We are well positioned in key seasonal categories such as Tractors, Mowers, Grills, Patio, and Air Conditioners, and we have new programs and products in place for key holidays, such as Memorial Day, Father's Day, and Fourth of July.
With that, I would now like to turn the call over to Paul.
Paul Raines - EVP US Stores
Thank you, Craig, and good morning, everyone.
As many of you know, one of our key priorities is associate engagement.
The store experience starts with how our associates are feeling about themselves and the company.
This business has a high emotional content, and morale and the emotional engagement with customers is vital to our success.
With over 364,000 associates, this is a challenge we continually face, but in a short period of time, we've made notable progress in associate morale.
I am getting a lot more e-mails from customers wanting to tell me about their great experience at the Home Depot.
It is evident that our associates are energized.
At our investor conference, we told you that we were going to make several investments.
One was to deleverage payroll expense as a result of our associate engagement initiatives.
We stayed true to that commitment in the first quarter.
We also shared with you that we reduced the number of metrics we hold store managers accountable for from 35 to 8.
This has allowed store managers to remain focused on what's most important, our customers.
We gave the stores a fun fund, $3,000 that could be used at the store manager's discretion to pump up their associates.
Since then, we have also done a number of other things.
During the first quarter, we launched a program to hire master trade specialists, particularly certified plumbers and electricians.
These specialists not only bring their experience and know-how to the store, but they also transfer knowledge to other associates and help boost morale.
While it is still early, we are pleased with this program.
We have changed our associates' compensation structure.
One of the ways we reward our hourly associates for great performance is through success sharing, which was historically based on a store achieving 100% of its goals.
This was not the market design, so like many other retailers, we changed the threshold to 95%.
Now associates feel more empowered and motivated to reach these goals.
I am pleased to say that for the first quarter, over 65% of our stores are on target to achieve success sharing.
We also continued our orange juiced program and reintroduced merit badges, which we call the Homer Badge.
Our Homer Badge program rewards associates for good performance or exceptional customer service.
Once you attain three badges, you can exchange them for cash.
You will soon begin to see the Homer Badges on the aprons of your favorite associates across the country.
We've strengthened the role of the regional merchandise manager or RMM in the merchandising process to ensure we are meeting the local product needs of our customers.
Before this change, the majority of merchandising decisions were centralized, but today, RMMs are able to adapt to the needs of customers by regionally allocating inventory.
One of Home Depot's traditional strengths has been our ability to adapt to local needs and drive regional differentiation.
We are returning to that core competence.
To Own the Pro, we are focused on a number of different initiatives to better service Pros, drive sales, and build loyalty.
One which I am really excited about is the Pro bid room.
The Pro bid room, which is now available in all of our stores, allows us to leverage the buying power of the Home Depot for the benefit of our Pro customers.
Our direct ship program allows us to have large orders delivered from our vendors to the customer's job site directly.
This reduces handling, lead time, and cost, and builds loyalty with this important customer.
The Pro bid room brings the power of the Home Depot to our customer's job site.
Another initiative that I'm particularly excited about are managed accounts.
We've identified our super-premium customers, that 2% of customers that represents 30% of our sales.
To better service these customers, we have begun adding more Pro sales managers to strategic markets.
Even though we are just starting to expand this program, accounts that are managed by a dedicated Home Depot Pro sales manager spend 50% more than unmanaged accounts.
As Frank mentioned, we've also continued to invest in programmatic store maintenance.
Year over year our spending on maintenance for general repairs, lighting, painting, and lot striping has more than doubled.
With all of these investments, we are starting to see results.
Through our voice of the customer surveys, we hear from approximately 200,000 customers a week.
Our latest results show that we are tracking above the year-ago period for all of our metrics, indicating increased satisfaction from those customers that shop in our stores and make a purchase.
We also know some customers have not shopped us recently, so we are working hard to make their next experience a great one.
Although the progress we are making in the stores is not evident in our financial results today, our attrition rates are down, the morale in the stores has improved significantly, and our voice of the customer scores tell us we are doing the right things for our associates and our customers.
I believe I have a good perspective on this.
I have worked in the store support center and have also had key operational roles as RVP and Division President.
I have a good understanding of the role that the store support center can play and the needs of the field and can bridge those two.
The Home Depot is a large enterprise and our reputation has been built through millions of customer experiences on the floor of our stores.
I am pleased to say that we are committed to enhancing that legacy one customer at a time.
I would now like to turn it over to Carol Tome.
Carol Tome - CFO, SVP - Corporate Affairs
Thank you, Paul, and hello, everyone.
In the first quarter, our total company sales grew by 0.6% to $21.6 billion.
We experienced sales growth of $977 million in our supply segment, but a sales decline of $830 million in our retail segment.
Sales in the retail segment were $18.5 billion, a 4.3% decrease from last year reflecting the impact of negative same-store sales of 7.6%, offset in part by sales from new stores.
Based on the slowing housing environment and tough year-over-year comparisons, we had planned for a negative comp of slightly over 5% for the quarter.
What we didn't plan for was unseasonably cold and wet weather in April.
The two coldest weeks in April accounted for two-thirds of the comp miss to our plan and the miss was found in the northern and southern part of the country.
Out west where the sun was shining, our western division beat its sales plan for the quarter.
Same-store sales were negative 7.4% in February, negative 5% in March, and negative 9.3% in April.
Now while still negative, same-store sales have rebounded and for the first two weeks of the second quarter are in-line with our expectation.
One more comment about retail sales.
While we missed our comp plan by more than 200 basis points, the market growth was down from what we expected by approximately 300 basis points, so we believe we performed better than the market in the first quarter.
As you heard from Frank, sales in the Supply segment were $3.1 billion, up 45.8% from last year.
We look at sales growth in this segment from an organic and an acquired perspective.
Given the challenging residential construction market, organic sales declined by 6.5% in the first quarter.
Consolidated gross margin was 32.9%, a decrease of 80 basis points from the same period last year.
Given the growth in our supply segment, we are experiencing a higher penetration of lower supply gross margin dollars.
In the first quarter, approximately 12% of our gross margin dollars came from display as compared to 8% last year.
Thirty-eight basis points of the consolidated gross margin decline in the first quarter was a result of a higher penetration of supply.
Supply's gross margin for the first quarter was 26.8%, down 94 basis points from the first quarter last year, the majority of which reflects a change in mix of businesses owned, namely Hughes Supply.
The remaining 42 basis points of contraction in our consolidated gross margin came from a decline in the retail gross margin.
Retail's gross margin in the first quarter was 33.8%, down 47 basis points from last year.
At our February investor conference, we told you that we anticipated a gross margin benefit this year arising from lower interest costs associated with our private label credit card financing program.
In the first quarter, we realized about 37 basis points of margin expansion from lower interest costs.
This benefit was offset by two main factors.
First, as Frank and Craig mentioned, we elected to accelerate clearance markdowns in support of our reset activity and our product line review.
Clearance markdowns cost us about 54 basis points in the quarter.
Second, we had a higher penetration of lower-margin categories like appliances.
This change in mix, along with the promotional activity that Craig mentioned, drove approximately 30 basis points of the year-over-year decline.
In the first quarter, consolidated operating expenses as a percent of sales increased by 199 basis points to 24.4%, consistent with our plan.
We experienced expense deleverage in both the Retail and Supply segments.
As a percent of sales, total expenses in the Retail segment grew by 217 basis points to 24.7%.
This deleverage occurred across every major expense category in support of our five key priorities.
For example, in addition to our recognition program, we elected to keep associates on the floor of the store, even though sales were softer than our plan.
In the first quarter, total payroll as a percent of sales increased by 76 basis points from the prior year.
One last comment about expenses.
While we will control expenses where we can, in a negative comp environment, it's very hard to leverage expenses.
We believe that for every point of negative comp, we will deleverage expenses by about 20 basis points.
As a result of the factors I just mentioned, the operating margin in both our retail and supply segments declined from last year.
On a consolidated basis, our operating margin for the first quarter was 8.5%, down 279 basis points from last year.
Net interest expense was $161 million in the first quarter, up $109 million from last year, reflecting higher levels of outstanding indebtedness.
Our long-term debt-to-equity ratio at the end of the first quarter was approximately 45% compared to approximately 24% one year ago.
In the first quarter, our income tax provision rate was 37.5%.
Diluted shares for the first quarter were 2 billion shares compared to 2.1 billion shares last year.
The reduction in outstanding shares is due to our share repurchase program.
In the first quarter, we repurchased 3.4 million shares and cumulatively since 2002 when our share repurchase program began, we have repurchased 454 million shares and spent $16.5 billion under our $17.5 billion authorization.
Now moving to our operational metrics, during the first quarter, we opened 26 new stores, closed two floor stores, and relocated one store for an ending store count of 2,170 stores.
Today, 230 stores, representing approximately 11% of our store base, operate in Canada, Mexico, and China.
At the end of the first quarter, selling retail square footage was 228 million, a 5.6% increase from last year.
The average square footage per store was 105,000 square feet, the same as last year.
Reflecting the sales environment, total sales per square foot were approximately $329 for the quarter, down 9.4% from last year.
In the first quarter, our new stores were 64% as productive as our comp stores, down from 66% last year and this reflects our changing store base.
Of the new stores that we opened over the last year, approximately 28% were in Canada, Mexico, and China.
Generally, these stores are less productive than U.S.
stores.
Now turning to the balance sheet, at the end of the quarter total inventory was $14.4 billion, an increase of $1 billion or 7.6% from the first quarter last year.
In the retail segment, on a per-store basis, retail inventory was up 0.2% from last year.
Inventory is higher than we planned, but that is because of the sales softness in April.
Our inventory lumps are in seasonal categories and we have already seen inventory drop as seasonal sales have strengthened in May.
Consolidated inventory turns were 4.3 times, down from 4.6 times last year.
Computed and beginning long-term debt and equity for the trailing four quarters, return on invested capital was 16.5%, reflecting our retail operating performance and lower returns in our supply business.
We ended the quarter with $56 billion in assets, including $2.1 billion in cash and short-term investments.
This is an increase of approximately $1.5 billion in cash and short-term investments from the end of fiscal 2006, reflecting cash flow generated by the business of approximately $2.8 billion, offset by $696 million of capital expenditure, $443 million in dividends paid, $91 million spent for share repurchases, and $31 million paid for acquisitions.
As Frank mentioned, we believe the home improvement market will remain soft throughout 2007.
We intend to continue our reinvestment plans for the long-term health of the business, understanding that it will put short-term pressure on earnings.
At the beginning of the year we provided earnings guidance and said that our earnings per share on a 52-week basis would decline by 4% to 9% in fiscal 2007.
Based on the drivers of our first quarter performance, we now believe we will be at the low end of our earnings guidance for the year.
Thank you for listening to today's call and we are now ready to take your questions.
Kenda, we are ready for questions, thank you.
Operator
Thank you.
(OPERATOR INSTRUCTIONS).
We'll go first to Matthew Fassler with Goldman Sachs.
Matthew Fassler - Analyst
Thanks a lot and good morning.
I want to focus first on Supply margins, if you would.
I think you spoke at your analyst meeting to slight operating margin expansion for that business for the year.
I realize that Hughes had a dilutive impact on the margins, but you did own it for part of the first quarter of last year.
So as you think about the earnings outlook for that piece of the business, would you say that it has perhaps come down from where you were at the outset of the year?
Carol Tome - CFO, SVP - Corporate Affairs
Well, good morning, Matt.
Supply's gross margin dropped 94 basis points in the first quarter from last year.
Seventy-five basis points of that was directly attributable to Hughes Supply.
Last month we had Hughes in for one month of the quarter, this year we had Hughes in for three months of the quarter.
Based on the guidance that we gave at our February investor conference, despite the fact that the residential construction market is challenging, we still feel comfortable with the guidance that we've given.
Matthew Fassler - Analyst
Got you.
That has -- that performance is not an issue as you look at the strategic review?
Does the first quarter number, if you will, from Supply impact the progress of that process?
Frank Blake - Chairman, CEO
I think we're pleased with the performance of the Supply business, again recognizing that they face some of the same issues in the housing market that you're all familiar with.
Matthew Fassler - Analyst
Got you.
For a quick follow-up, the share repurchase number was a much slower run rate than we have typically seen, although obviously, we're still early in the year.
How should we think about that $90 million spent on repurchases and think about the outlook for buybacks for the rest of the year?
Frank Blake - Chairman, CEO
Matt, generally, we've said we're going to wait until the end of our strategic review process with Supply and then come out with a more general framework around what we're going to do on capital and our share repurchases.
Matthew Fassler - Analyst
Fair enough.
Thank you so much.
Frank Blake - Chairman, CEO
Thanks, Matt.
Operator
We'll go now to Gary Balter with Credit Suisse.
Gary Balter - Analyst
Thank you.
Frank, first of all, I just want to say that just visiting stores, you see such a difference in the employees, so whatever you're doing, keep it up.
Frank Blake - Chairman, CEO
Thank you, Gary.
It's a lot of people other than I, obviously.
Gary Balter - Analyst
Yes, it's the whole team, but you can see the difference.
A question for you -- that wasn't a question, so I still get my two.
A question for you, at the conference in February, you talked about 10% -- about operating margins going from 11.4% to 11.9% at retail between '06 and 2010.
It looks like this year is going to come in maybe 10ish, 10.2%, somewhere in that range.
Are you still comfortable as you look out to 2010 that you can turn it around that rapidly given the investments you need and given what you are seeing already?
Frank Blake - Chairman, CEO
As we talked about at the conference, we see such enormous opportunities around our supply chain and Mark is actually here in the room and he's -- we're starting to make -- it's -- we're very, very early in that process, but that was really the bulk of where we saw the potential for operational efficiency and improvement and we remain very optimistic about that.
Gary Balter - Analyst
As part of that, how dependent is the supply chain on getting the SAP system working effectively?
Frank Blake - Chairman, CEO
It's highly dependent on that.
Mark, you might want to comment on that.
Mark Holifield - VP Supply Chain
Yes, as you know, we have the core retail SAP implementation going forward in Canada, and we're just at the early stages of beginning the plans to get that going in the U.S., but we're on track pretty much with our plans in Canada and expect to pilot with our first stores later this year.
Gary Balter - Analyst
Okay.
Then the second question is, Appliances obviously has a lower gross margin.
That's been an area you've been focusing on.
Can you walk us through the operating margin difference between selling products such as Appliances versus your core products?
Carol Tome - CFO, SVP - Corporate Affairs
From an operating margin perspective?
Gary Balter - Analyst
Like, is there a difference -- is there a dedicated labor force -- do you make it back, in other words, on the operating margin line, or is this just something that's going to drive down margins as you grow in these businesses?
Craig Menear - EVP - Merchandising
Well, we do have a dedicated -- this is Craig, sorry.
We do have a dedicated team that from a labor standpoint that is involved with our Appliance business, but in total we look at our sales in the Appliance category and the growth in that business as part of driving overall top-line sales productivity, and we're looking for a margin mix in total that would bring the bottom line in conjunction with where our plans would project them to be.
We're not necessarily looking for a individual category look, we're looking at a total mix look.
Carol Tome - CFO, SVP - Corporate Affairs
But it's fair to say we make money on Appliances.
Gary Balter - Analyst
Okay, thank you.
Operator
We'll go now to Colin McGranahan with Bernstein.
Colin McGranahan - Analyst
Good morning.
Wanted to focus a little bit on the gross margin line and understanding obviously the first quarter was a difficult quarter from a clearance event and a seasonal event, but just want to try to understand the trade-off that you're looking at between comp growth and driving traffic, driving the excitement, which I know is one of the three -- or the five major initiatives.
I'm not -- I just want to try and get a little bit more understanding of how you're thinking about promotional event and whether given the clearance activity in the first quarter you still would expect gross margins in the retail business to be up for the year?
Frank Blake - Chairman, CEO
Well, I think -- first, I would make a comment on that and turn it to Craig.
As he commented, we did some promotional events in the first quarter.
Frankly, take this on myself in response to the sales environment that didn't pay out, that weren't the smartest thing to do and I think as we go forward, the way we're thinking of our promotional events is to make sure they're more impactful and make more sense in terms of driving transactions in our store and yielding gross margin dollars.
Craig Menear - EVP - Merchandising
This is Craig.
In terms of, when you look at the margin impacts, we made a conscious decision to accelerate clearance in the first quarter, really looking to take advantage of some of the peak traffic time that we have in our store.
Obviously, didn't anticipate the weather impact of the first couple weeks of April, which also put a little bit more of a negative spin on our clearance plan in the quarter.
We will be less promotional as Frank said, moving forward.
I think that it's fair to say mix is difficult for us to predict as we move forward.
Carol Tome - CFO, SVP - Corporate Affairs
If I could just jump in from a guidance perspective, based on the drivers of the first quarter performance, we're comfortable with the guidance that we gave on sales for the year, which was mid-single digit negative comps.
We did have gross margin guidance as well.
We're comfortable with the low end of that gross margin guidance, which is in the 20% -- or 20-basis point range.
Colin McGranahan - Analyst
Okay.
Then Carol, while I've got you, just a quick follow-up.
CapEx in the first quarter seemed a little bit light versus our expectations.
Is that still on track for the year?
Carol Tome - CFO, SVP - Corporate Affairs
Just a little bit about our capital spending programs.
As you can appreciate, this is the busiest time of the year for us, and so we don't want to put a lot of activity inside the stores when our customers are there.
So you'll see the capital start to really take off in the second, third and fourth quarters.
Colin McGranahan - Analyst
Okay, great.
Thanks.
Frank Blake - Chairman, CEO
Thank you.
Operator
We'll go now to Budd Bugatch with Raymond James and Associates.
Budd Bugatch - Analyst
Thank you and good morning.
Payroll to sales, you said, went up 70 basis points in Q1.
Could you kind of reflect that versus what the plan might have been and maybe tell us how we should think about payroll to sales for the rest of the year?
Carol Tome - CFO, SVP - Corporate Affairs
Sure, I'll start and Paul, you might want to jump in.
We were actually over hours in the first quarter, so relative to our plan, the expense deleverage was a little bit more than we anticipated, but we're okay with that.
We want to keep people on the floor of the store and we're not coming off the guidance that we gave that we'll keep the associates on the floor of the store.
Paul Raines - EVP US Stores
Absolutely.
Budd, this is Paul.
As you know, we've made a significant commitment beginning in the back half of last year to our voice of the customer projects and service and we remain committed to that and we'll continue to see it through the rest of this year.
Budd Bugatch - Analyst
I understand and appreciate that.
I just wonder whether 76 basis points is kind of a proper run rate to expect for the rest of the year, or maybe just two-thirds of that or somehow you can give us a feel for that.
Carol Tome - CFO, SVP - Corporate Affairs
Sure, Budd, I think that's a very fair question.
Sales were soft, clearly down almost 8% on a comp store basis so that deleverage that we experienced in the first quarter is not what we expect to have going forward, because we're not expecting a negative 8% comp for the balance of the year.
Budd Bugatch - Analyst
Okay.
Two other areas, just quickly.
Soft flooring has been very weak for a long time.
I think the comp performance in the first quarter was maybe amongst maybe the poorest in the stores, if our suppliers are telling us right.
What are you doing to fix that?
And did I hear you right that you closed both floor stores in the quarter?
Frank Blake - Chairman, CEO
We are, we did, Budd.
So I did not think that that pilot was particularly a good idea or yielded the results we expected.
And we're doing a number of things across soft flooring in the stores and as you can appreciate and again I'll let Craig comment to some of the specifics.
As you can appreciate, this is one of those items that goes from what the appearance of the store, because it's a decor kind of sale, the product that we carry in the store, and then the connection to our installers, because such a large percentage of that product, we install.
And so getting the right coordination from sale through to installation is a key part of getting that business right.
Craig, do you want to make a couple of additional?
Craig Menear - EVP - Merchandising
Yep.
Budd, if you look at our key actions that are taking place in the soft flooring market, we are focused on assortment.
There are several assortment changes that are coming forward and are being implemented in the store, really as we speak.
As Frank mentioned, presentation, so we will begin to have some showroom upgrades in this category as well and then of course we're focused on trying to simplify the offering for our customer from an installation standpoint.
So all three of those are key action areas that we're focused on right now.
Budd Bugatch - Analyst
When do you expect some positive comps in that particular area?
Craig Menear - EVP - Merchandising
Well, we are seeing improvement begin in the category, we're a long ways from the category being where we want it to be.
Carol Tome - CFO, SVP - Corporate Affairs
I think we should just go ahead and tell you what flooring was because it wasn't one of the worst comping departments in the store.
Flooring for the quarter was down 8.7.
Craig Menear - EVP - Merchandising
Yeah, I understand that, Carol, but that included the hard as well.
I was just thinking about soft being that area.
Frank Blake - Chairman, CEO
The other thing I would add, Budd, in terms of your question of when this turns around, one of the areas where we've achieved the most success is frankly having intensive -- more intensive training for our associates on the floor.
So if you looked across the whole range of things that we've done, and we've been working in this -- this isn't a first quarter issue, this has been a multiyear issue, that's been one of the ones that's had the most encouraging performance in terms of turning it around to positive comps.
So we're now looking at, okay, how do we take those pilots and extend them more broadly.
Budd Bugatch - Analyst
That is exciting, Frank.
My last question, Carol for you, is did I understand you the quality of the inventory is in good shape, that you have now with the better weather, the quality is okay and the amount of clearance should be therefore reduced in upcoming quarters?
Carol Tome - CFO, SVP - Corporate Affairs
Yes.
The inventory lumps are in the seasonal categories.
It's Patio, Grills, Tractors, this is good stuff and we're starting to see the inventory come down as the sales have improved.
Budd Bugatch - Analyst
Okay.
Thank you very much.
Frank Blake - Chairman, CEO
Thank you, Budd.
Operator
We'll move now to Steve Chick with JPMorgan.
Steve Chick - Analyst
Hi, thank you.
Just a couple of questions.
I guess, Paul, you had outlined a projection of $200 million of payroll deleverage, I think, for 2007 I guess back at the analyst presentation and I was wondering if you could speak to the payroll deleverage in terms of that target for the year and then secondly, to that, with that and the $100 million investment that you made at the end of the second half, are you seeing improved customer service levels and sales related to the dollars that you're allocating to that investment?
Paul Raines - EVP US Stores
Yes, Steve, this is Paul.
Maybe I'll start with talking about the second piece of that and I'll let Carol answer the first piece.
I think we are seeing improved results.
If you say our V.O.C.
metrics were clearly ahead year over year on all of those metrics, we are seeing a significant improvement in the customer experience on all of those metrics.
We also have a significant morale improvement in our stores, which as you know, our associates, the ability to take care of customers is a big driver of their own morale.
So we're pleased with that and we think that's part of it.
In terms of the deleverage, I think the main issue for us is we're going to continue to fund the activities in the store based on what our service model is and we don't expect to see the kind of impact, top line, that we saw in the first quarter.
And Carol, I don't know what you want to say about the deleverage.
Carol Tome - CFO, SVP - Corporate Affairs
That's right, we're on track.
Steve Chick - Analyst
Okay.
But I guess - so for the $200 million, if I just take, simplistically take 76 basis points of deleverage this quarter and look at it relative to retail sales, I don't know if it's too simplistic to look at it that way, but that's about $140 million of deleverage.
Is it too simplistic to look at it that way?
Carol Tome - CFO, SVP - Corporate Affairs
The payroll number I shared was total payroll inside the store, and what Paul is referring to is hourly payroll.
So I think we need to back that out.
Hourly payroll, we deleveraged by about 36 basis points in the first quarter.
Maybe that's helpful.
Steve Chick - Analyst
Okay.
So the target you've set out, I mean, you think that's the right type of investment you need to make with hours in the stores?
Frank Blake - Chairman, CEO
I would also say, it's not as though we started this and said it's a $200 million bucket, and where are we on the $200 million bucket?
It's much more, as Paul said, what do we need on the floor of our store to adequately serve our customers?
Look, what happened to us on the first quarter was we kept to that despite some pressure on the sales.
So if the bucket is slightly more or slightly less than the $200 million, that's going to float a bit with what the sales are.
Steve Chick - Analyst
Okay.
Second question, if I could, Frank, just in terms of the process with Home Depot Supply, you know, I understand the sensitivities around speaking to it, but it was February 12, I think that you mentioned you were evaluating the review.
I guess we're all kind of anxious to hear the end of that evaluation but it's a little surprising that you haven't decided yet.
Can you kind of speak to what the delay is, so to speak, and how things are going with the process?
Frank Blake - Chairman, CEO
Sure, I would be happy to.
Just so you know my mind-set, I have to say I don't see this at all as a delay so we're 90 days, give or take 90 days into the process and truly, as every -- as you can well imagine, this wasn't something that we've been thinking about 90 days before or 120 days before, so we're 90 days into the process and I think if you ask most folks what this kind of process takes, something between 90 and 180 days -- 90 days would almost be unheard of.
180 days is probably more the norm.
We'll be -- we're, I think, going to be a lot more expeditious in this but I don't see this as a delay at all.
Steve Chick - Analyst
Okay.
But are you pretty encouraged by the process in terms of feedback and interest level and things like that in the event you go that route?
Frank Blake - Chairman, CEO
I think -- look.
There's a lot of things we think about on a strategic evaluation process.
One is the interest from other people in the assets and I think we've got some strong interest in the assets and then the other part is our own internal evaluation of what's the best thing for our shareholders with these assets.
Steve Chick - Analyst
Okay.
Will we hear a conclusion by the end of next quarter, do you think?
Frank Blake - Chairman, CEO
This is what I wouldn't comment on.
Steve Chick - Analyst
Okay, thanks.
Operator
Thank you.
We'll go now to Eric Bosshard with Cleveland Research Company.
Eric Bosshard - Analyst
Good morning.
Frank Blake - Chairman, CEO
Hey, Eric.
Eric Bosshard - Analyst
Can you talk a little bit about how you're going to get customers back into the store?
It seemed like Craig commented that from a promotional spend that you would be less promotional in 2Q and I'm just curious how you're going to get -- how you expect to get customers back into the store to see the improved morale, improved energy in the store, improved execution?
Frank Blake - Chairman, CEO
First, I'll give a general comment on that.
To my mind, there's a difference between promotional activity and offering compelling values.
The compelling values will drive footsteps into our stores and that's what we have to be focused and never lose our -- just that proposition to our customers.
Then I would also say, if you look at where we are in the market, probably one of our biggest opportunities is conversion.
Converting the customers who come into our stores as it is now.
We are the top of mind home improvement retailer.
So it's -- fortunately, we're not faced with just an issue of, gee, do I want to go into Home Depot, but when I'm in Home Depot looking at this category, do I see the compelling value, do they have the product that I want?
Craig, I don't know if you want to add to that?
Craig Menear - EVP - Merchandising
Eric, it's really continuing to work the merchandising strategy that I laid out at the conference.
We have to continue to focus on improving our offering, as Frank has mentioned, as it relates to not only the value proposition but the line structure and then really making sure that we communicate those values to our customers properly through our marketing efforts.
Eric Bosshard - Analyst
Great.
Then just a follow-up for Carol, if I could.
In terms of the guidance, Carol, you said you're now at the low end of the earnings guidance but maintaining what sounds like the same comp guidance.
Is the deviation for the year just reflective of what happened in 1Q, or do you have a different perspective of how the rest of the year will lay out versus what your prior expectations were?
Carol Tome - CFO, SVP - Corporate Affairs
Clearly, there's an impact to the first quarter, because we were below our earnings plan for the first quarter.
As we look out for the remaining quarters, the change in our guidance really is on a gross margin line, where we believe we will have margin expansion, but it won't be on the high end of the margin expansion that we had guided to earlier in the year.
Eric Bosshard - Analyst
Thank you.
Frank Blake - Chairman, CEO
You're welcome.
Diane Dayhoff - SVP IR
Kenda, we have time for one more question.
Operator
And we will take our final question from Chris Horvers with Bear, Stearns.
Chris Horvers - Analyst
Thank you, good morning.
Frank Blake - Chairman, CEO
Hi, Chris.
Chris Horvers - Analyst
Can you talk about the Bay reset program for the year and how deep you are into that and how we should think about clearance activities looking forward?
Craig Menear - EVP - Merchandising
Chris, this is Craig.
In terms of our merchandising resets, we are on track to continue driving change within our stores through multiple categories.
You'll see that begin to ramp up a little bit more heavily as we move towards the back half of the second quarter.
As Carol mentioned earlier, we do try to purposefully keep some of the activity out of this high-traffic time frame so that we don't disrupt the stores.
Chris Horvers - Analyst
So does that -- so should we expect clearance activity to also pick up in-line with that?
Craig Menear - EVP - Merchandising
We accelerated clearance in the first quarter and we'll see a more normalized clearance approach going through the balance of the year.
Chris Horvers - Analyst
Okay.
On a related question, as we think about the payroll and the maintenance spend on the stores, the cadence of that spending as we look throughout the year, how do you look at that?
And does the fact that we really started some of these programs in the back half of last year make it less of a drag in the back half?
Carol Tome - CFO, SVP - Corporate Affairs
As we mentioned at our investor conference, in support of our five key priorities, we're spending about $1.6 billion in capital, about $600 million in expense.
You're going to see that drag, if you will, in every quarter.
But we're investing for the long-term.
Chris Horvers - Analyst
Yep.
So but the fact that you spent $500 million or so in the back half of last year, you're going to spend the incremental on top of that?
Carol Tome - CFO, SVP - Corporate Affairs
We're spending.
Chris Horvers - Analyst
Okay.
Frank Blake - Chairman, CEO
Again, it's important -- while we spent, we also in the back half of '06, we also know that just programmatically, there are improvements we have to be making in our stores.
Chris Horvers - Analyst
Finally, as you think about the big ticket categories like Kitchen and Bath, clearly expected that to be a drag on the comp perspective.
How is that versus your expectations?
Was it worse?
Did April have an impact and maybe saw some marginal or sequential improvement in May?
Craig Menear - EVP - Merchandising
Chris, this is Craig.
I would say that it's fair to say in some of the big-ticket category spending, it was a little bit more difficult than what we had anticipated.
Chris Horvers - Analyst
Okay.
Any improvement in the back half of the quarter or May?
Frank Blake - Chairman, CEO
I'd say it's still a little early.
Carol Tome - CFO, SVP - Corporate Affairs
Two weeks into May.
Chris Horvers - Analyst
Okay.
Frank Blake - Chairman, CEO
All right.
Chris Horvers - Analyst
Thank you.
Frank Blake - Chairman, CEO
Thank you all very much.
Carol Tome - CFO, SVP - Corporate Affairs
Thanks for joining us.
Frank Blake - Chairman, CEO
Thank you.
Carol Tome - CFO, SVP - Corporate Affairs
Bye-bye.
Operator
That does conclude our conference for today.
Thank you all for your participation.
Have a great day.