家得寶 (HD) 2014 Q2 法說會逐字稿

Good day and welcome to The Home Depot Q2 2014 earnings call. Today's conference is being recorded. (Operator Instructions). At this time, I would like to turn the conference over to Ms. Diane Dayhoff, Vice President, Investor Relations.

Thank you, Audra and good morning to everyone. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, President, US Retail; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services.

Following our prepared remarks, the call will be open for analyst questions. Questions will be limited to analysts and investors and as a reminder, we would appreciate it if participants would limit themselves to one question with one follow-up please. If we are unable to get to your question during the call, please call the Investor Relations department at 770-384-2387.

Now 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 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These risks and uncertainties include, but are not limited to, those factors identified in the release and our filings with the Securities and Exchange Commission. Today's presentations may also include certain non-GAAP measurements. Reconciliations of these measurements is provided on our website. Now, thank goodness, let me turn the call over to Frank.

Thank you, Diane and good morning, everyone. Sales for the second quarter were $23.8 billion, up 5.7% from last year. Comp sales were positive 5.8% and our diluted earnings per share were $1.52. Our US stores had a positive comp of 6.4%. We saw broad-based growth in the quarter across all of our geographies. All three of our US divisions posted mid-single digit comps with the variance of performance within 100 basis points of each other. We are pleased with these results since we were anniversarying double-digit comps in the second quarter of last year. Every region positively comped as did 38 of our top 40 markets. Our Mexican business positively comped for the quarter making it 43 quarters in a row of positive comps. And our Canadian business continues to perform well with positive comps for the 11th consecutive quarter.

Our dotcom business had sales growth of over 38%. This was a slight deceleration from the first quarter, but it was well ahead of our plan. This quarter, our sales comparison included the full rollout of Buy Online Ship to Store, which we launched last year.

While our year got off to a slow start because of the late spring, we ended the first half with sales in line with our original expectations. We believe the housing market remains a modest tailwind for our business. We had growth in transactions and ticket for both the quarter and the half. Both our consumer and pro businesses grew, our installation services business, which is high ticket and tends to be on the discretionary end of spending, had a strong quarter. And as Craig will detail, we saw an acceleration of big-ticket transactions. These results support the view of a continuing recovery in the US home improvement market.

Consensus GDP forecasts call for modest growth for the year and though the housing data is mixed, we believe home price appreciation is an important positive for our business. Price appreciation isn't setting the pace of last year, but it is still going in a positive direction, consistent with our expectations at the start of the year. As Carol will detail, we are reaffirming our sales guidance and increasing our earnings-per-share guidance for the year to reflect our outperformance this quarter and our outlook for the remainder of the year.

Let me close by thanking our associates for their hard work and dedication. A successful spring season for us requires flexibility in a difficult environment and our associates met the challenge. This half, over 97% of our stores qualified for Success Sharing, our profit-sharing program for our hourly associates. We are proud of this result and hope to do even better in the second half. With that, let me turn the call over to Craig.

Thanks, Frank and good morning, everyone. We were pleased with our results in the second quarter and saw continued strength in the core of the store in maintenance and repair categories. Our online business continued to show strong growth and our pro and service businesses had another quarter of solid performance. We also experienced a rebound in our seasonal businesses as spring broke across the country.

I would like to thank our store associates, as well as our inventory, planning, replenishment and supply chain teams who responded to this surge in seasonal sales. Because of them we were able to deliver a great quarter and we had some of our highest customer service scores in history for the second quarter. This is particularly notable given the fact that we had a record number of customer transactions.

From a geographic perspective, all three US divisions had positive comps and beat their sales plan. All departments had positive comps for the quarter. The departments that outperformed the Company's average comp were tools, millwork, outdoor garden, electrical and kitchens. Bath, decor, plumbing, hardware, paint, building materials, indoor garden, flooring, lighting and lumber were at or below the Company average, all at mid-single digit comps.

The core of the store continued to perform well as we saw strength in maintenance and repair categories across the country. Appliance parts, HVAC, hand tools, power tool accessories, water heaters and lightbulbs all had double-digit comps. Pro heavy categories like windows, concrete, insulation, pressure-treated wood, studs, fasteners, pipe and fitting and gypsum had comps above the Company average.

Seasonal outdoor categories regained strength in the quarter. We lost some sales in air movement categories due to the cooler summer and in live goods in drought-affected areas. However, sales in exterior stains, water sealers, grills, seed, soils, mulch and live goods in non-drought affected areas more than made up for the loss.

In simple decor, vanities, decorative lighting, fixtures and hard surface flooring led by laminate, tile and hardwood all had comps above the Company average. Appliances also had another quarter of outperformance, posting double-digit comps.

Total Company transactions grew by 4.1% for the quarter while comp ticket increased 1.7%. Our average ticket increase was negatively impacted by commodity price deflation mainly from lumber and copper. The total impact to ticket growth from commodity price deflation was approximately negative 10 basis points.

Transactions for tickets under $50 representing approximately 20% of our US sales were up 3.1% for the second quarter. Transactions for tickets over $900 also representing approximately 20% of our US sales were up 8.4% in the second quarter. The drivers behind the increase in big-ticket purchases were appliances, windows, water heaters, wood and laminate flooring.

Our pro business was strong across the country. Total pro sales grew at approximately the Company average, but sales from our high spend pro customers, which we define as those who spend more than $10,000 year with us, grew above the Company average for the 10th quarter in a row. Our services business also had another great quarter posting comps over twice the Company average. And services, solar, window, HVAC and countertop installations were the main sales drivers during the quarter.

We continue to derive efficiency through multiple initiatives. While in the early days, our new merchandising tools are starting to deliver benefits. For example, we can use clustering to better assort stores with similar attributes. One category where we have seen this success is in water heaters that were assorted based on local preferences, regulations and demographics and as previously mentioned, this category had double-digit comps for the quarter.

We have also changed the way we communicate with our customers and have shifted our approach to support a more targeted personalized messaging to become more relevant to the customer. As a result, costs attributable to traditional print advertising have been reduced by over 60% since 2010 and have been shifted to a more efficient digital delivery method.

Now let me turn our attention to the merchandising and operational activities in the third quarter. We continue to drive leadership in LED technology and are excited about the launch of our new lightbulb reset that will expand our presence and holding capacity in the category. This reset will add 25 new SKUs to our assortment and provide for a better, more intuitive shopping experience for the customer. We are also introducing new products for the connected home, including garage door openers, thermostats, water heaters and lightbulbs. In addition to these new products, we have an incredible lineup of great values and special buys for our Labor Day and fall cleanup events.

Finally, we continue to enhance the customer service experience in our stores and provide our associates the tools necessary to do so. In the second half of 2014, we are introducing the next generation of our First Phone, which is an associate and customer service tool. It will allow for Internet access to assist with questions and online orders and will be equipped to complete the checkout process in aisle for our customers. These exciting products, events and tools will allow our associates to be ready for success in the third quarter.

And before I turn the call over to Carol, I would like to congratulate Ted Decker, who was recently promoted to Executive Vice President of Merchandising. Ted brings a wealth of knowledge and Home Depot experience to this role. With that, I would like to turn the call over to Carol.

Thank you, Craig and hello, everyone. In the second quarter, sales were $23.8 billion, a 5.7% increase from last year. Our total Company comps or same-store sales were positive 5.8% for the quarter with positive comps up 6% in May, 4.4% in June and 6.8% in July. Versus last year, a stronger US dollar negatively impacted total Company comps by approximately 50 basis points. Comps for US stores were positive 6.4% for the quarter with positive comps of 6.6% in May, 5% in June and 7.3% in July. We were particularly pleased with our US comp performance given that last year we posted an 11.4% positive comp in the second quarter.

Our total Company gross margin was 34.3% for the quarter, a decline of 1 basis point from last year. We saw a considerable amount of movement in our gross margin during the quarter as explained by the following factors. First, we experienced 16 basis points of gross margin expansion due primarily to higher levels of co-op and rebate and a modest positive impact from sales mix changes. This gross margin expansion was offset by 11 basis points of contraction due to higher shrink than one year ago and by 6 basis points of deleverage coming from our supply chain as we, like many companies, faced higher transportation costs.

For the first six months of the year, our gross margin was essentially flat from the prior year and for fiscal 2014, we expect our gross margin rate to be up a few basis points from what we reported in fiscal 2013. In the second quarter, operating expense as a percent of sales decreased by 109 basis points to 19.8%. While our expense leverage reflects the impact of positive comp sales growth, we also experienced lower expenses year over year in several areas, including workers' compensation.

Further, management bonus expense was $66 million less than last year given relative year-over-year performance. Based on our year-to-date experience and our outlook for the balance of the year, we are now projecting our fiscal 2014 expenses to be lower than what we thought at the beginning of the year. As a result, we are projecting our fiscal 2014 expenses to grow at approximately 23% of our sales growth rate. We would expect our expense growth ratio to be higher than our guidance in the third quarter and closer to our guidance in the fourth quarter given year-over-year comparisons.

Interest and other expense for the second quarter was $191 million, a $19 million or 11% increase from last year. The year-over-year change reflects two items. First, interest expense increased by $34 million due primarily to interest associated with long-term debt. Year over year, we have increased our outstanding debt by $4 billion, including $2 billion of long-term debt issued in June of this year.

Second, interest and investment income increased by $15 million in the quarter reflecting an additional gain on sale of HD Supply common stock. This brings the total pretax gain on sale of HD Supply common stock to $112 million or approximately $0.05 of earnings per diluted share for the first six months of 2014, of which $0.04 was recognized in the first quarter and $0.01 was recognized in the second quarter. We now own approximately 11.8 million shares, or 6%, of HD Supply outstanding shares.

Our income tax provision rate was 37.1% in the second quarter and we expect our income tax rate to be approximately 37% for the year. Net earnings for the second quarter were $2.1 billion, the highest quarterly net earnings in our Company's history. Diluted earnings per share for the second quarter were $1.52, an increase of 22.6% from last year.

During the second quarter, we opened one new store in Mexico for an ending store count of 2,264. At the end of the second quarter, selling square footage was 236 million and total sales per square foot were $404, up 5.5% from last year.

Now turning to the balance sheet, at the end of the quarter, inventory was $11.7 billion and inventory turns were 4.9 times, flat to last year. We ended the quarter with $43.5 billion in assets, including $4.2 billion in cash and cash equivalents.

Moving to our share repurchase program, in the second quarter, we repurchased $2.25 billion, or 23.1 million of our outstanding shares. This included 6.2 million shares repurchased in the open market and 16.9 million shares repurchased through an accelerated share repurchase or ASR program. For the shares repurchased under the second-quarter ASR program, this is an initial calculation. The final number of shares repurchased will be determined upon completion of the ASR in the third quarter. For the remainder of the year, we intend to repurchase approximately $3.5 billion of outstanding stock using excess cash and the proceeds from $2 billion of long-term debt issued in June for total fiscal 2014 share repurchases of $7 billion. Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital was 21.9%, 280 basis points higher than the second quarter of fiscal 2013.

Moving to our guidance, there are mixed signals in the housing data, but our planning assumptions remain intact. As we look to the back half of the year, we believe we will continue to report solid sales gains and the sales plan we laid out at the beginning of the year is well within site. Today, we are reaffirming our sales growth guidance for the year of approximately 4.8% and comp sales growth of approximately 4.6%. We expect the rate of comp growth for the back half of the year to be about 80 basis points higher than the rate of comp growth we experienced in the first half of the year.

For earnings per share, remember that we guide off of GAAP. We are lifting fiscal 2014 diluted earnings per share growth guidance by $0.10 and now expect fiscal 2014 diluted earnings per share to increase approximately 20.2% to $4.52. Our updated earnings-per-share guidance reflects our second-quarter performance, as well as the impact of raising our 2014 share repurchase target from what had been $5 billion to now $7 billion. So we thank you for your participation in today's call and Audra, we are now ready for questions.

(Operator Instructions). Aram Rubinson, Wolfe Research.

Hi, this is Chris Bodiclary on for Aram. I just want to ask the question if you could tell us about your decision-making process that you are using to deploy and optimize space in your stores. Specifically we are wondering -- like we've seen you reset patio, flooring, cabinets. What are the other glaring opportunities -- what figures internally tell you that space allocation is making a difference? And lastly, if you were to change the allocation overnight, like what do you think the ultimate potential could be in terms of sales per square foot or anything else you can tell us? Thank you.

So Chris, from a space allocation standpoint, we obviously use both our financial systems, as well as our planogram software systems to be able to make decisions on the productivity of space. The investments we've made in our merchandising tools are there to allow for our merchants to make assortment decisions that improve the productivity of obviously the space that we dedicate to our assortments. You have seen us make trade-offs, as you pointed out, in terms of allocation shifts within patio. In this case, as we've seen customers gravitate to the online space and the ability to customize their own product through the offerings that we have digitally, that would be much more difficult to execute in a store environment or in spaces like kitchens where the customer's shopping pattern has changed in terms of how they begin to shop for kitchens and we could take some space out of kitchens, for example, and either apply that to an expansion of our assortment in appliances or for that matter our hard surface flooring. So those are the type of trade-offs that we will make on a consistent basis and look for opportunities to continue to drive productivity overall in our store, but for our sales in total.

And to your question as to how high is up, well, that is for us to figure out, but if we just look at appliances, for example, we have our expanded assortment in over 800 of our stores. We are rolling to another 183 stores and appliances contributed 50 basis points of our comp growth in the second quarter.

That's great. Thank you very much.

Dan Binder, Jefferies.

Hi, good morning and congratulations on a great quarter. My question was -- I had two questions, one around just the momentum you are seeing at the end of the quarter. Anything that you would attribute to that, any promotional events and has that continued into Q3?

So when we look at the quarter and through the months, very, very pleased, Dan, with the breadth of growth, if you will, across the store. Probably one of the tightest quarters in terms of when we look at all of our departments, the lowest comping department was north of 4% and the spread was pretty narrow. So we are very, very pleased with the productivity across all of our merchandising departments and also across all of our geographies.

And as we look into our performance for August, you may recall that last year our comp in August was 8.7%. So we are up against our hardest comparison and we are very pleased with our sales performance.

Great. My second question, if I could, was just around the SG&A. The lower incentive comp was detailed. I was wondering if you could give us any color around the workers' comp impact to the quarter.

Sure, I would be happy to. We've really worked -- Marvin and team have done a marvelous job of working on really making our stores a place where we have fewer injuries, etc. And so our workers' compensation expense was $42 million down year on year.

Great, thank you.

Simeon Gutman, Morgan Stanley.

Good morning. This is Joshua Siber on for Simeon. Congratulations on a great quarter. So outside of the lower workers' comp, you guys posted nearly flat SG&A dollar growth versus nearly 6% sales growth. Just outside of the workers' comp, do you attribute that expense control to anything else?

There were a few other items I would call out -- a legal settlement that we had last year of $23 million that didn't repeat this year. But broadly speaking, we have a productivity cycle that drives our economic engine and we have a laser focus on just making sure that we have got outstanding expense control and you can see that in the results.

Okay. And if you don't mind if I sneak one more in. Just curious how have customers responded to a dedicated space for online orders? Have you guys seen a pickup in the pro business because of this?

Roughly about a third of our online transactions culminate in a store and that is split across both consumer and pro.

Okay, thank you very much.

Kate McShane, Citi Research.

Thanks, good morning. For Q2, we assume that some of the comp benefit was from storm-related damage sales. Do you expect to still see some impact from this in Q3?

The overall storm comp from a year ago, as you move into Q3, is very, very small. We have pretty much cycled through it as we have come off of Q2.

Are you referring, Kate, to the damage from the winter that we had?

Yes, damage from the winter.

It's hard, to be honest, to tease that out in the numbers. What you saw was a very strong recovery of our outdoor garden business, but we are not able to pinpoint what percent of that came from storm damage.

And to Craig's comment about the storms that we are anniversarying from Superstorm Sandy, this might be helpful to you. If you look at our six-month comp in the United States, it is a 5% comp. We had about 50 basis points of pressure in that comp coming from the Superstorm Sandy overlap and to Craig's point, we will be through that beginning in Q3.

That's very helpful. Thank you.

Brian Nagel, Oppenheimer.

Hi, good morning. Congratulations on another very nice quarter. The question I had, you called out big ticket as a driver here and I think in response to one of the other questions, you mentioned appliances. But the question I have is maybe give us a little more color around either the ongoing strength you are seeing in the appliance category or if you are seeing big ticket of another nature start to inflect higher here at this point in the cycle.

We were very pleased, Brian, with our performance in appliances. Double-digit comp growth, as Carol mentioned, 50 basis points of overall comp contribution and that is a result of obviously the expanded assortments and the expanded showroom. We also believe we are delivering great value in our events that we put into play there, but also in big ticket, we have seen a nice recovery in the millwork business as customers clearly feel better about investing in their homes. We have had an outstanding product in terms of our expansion and use of tools to put our new water heater program in place, as well as growth within our flooring business led by wood and laminate with the investments that we have made into our hard set program there. Roughly we began the year with about 225 stores with an expanded assortment. By the end of this year, we will have about 600 with an expanded presence there. So it is more than just appliances that we are seeing and as our large pro continues to recover, our pro is driving a larger ticket than the consumer basket on a consistent basis.

I might just also call out services because they had such a terrific quarter. They comped twice the Company average and the average ticket within our services business is $1500.

Very helpful. And then just a quick follow-up. Marketshare? Any color you can give us there on the heels of a strong showing in sales?

Well, our area, Brian, is really hard to -- I mean we look at third-party reports on marketshare, government reports on marketshare, what our vendors say about marketshare and they would say it is going in the right direction.

Thank you. Congrats again.

Christopher Horvers, JPMorgan.

Hi, this is actually Mark Becks on for Chris. Congrats on the great quarter. First question, just trying to get a sense -- we previously talked about the potential bathtub effect and impact from weather unseasonable versus what is going on in the core of the store. It is possible to put a number or a comp benefit that you think you captured just in terms of share shift in volume from Q1 to Q2 and then if you could give a little bit more detail on the core trends of the business? Thanks.

Sure. I mean this is imperfect, but directionally correct. So in the United States, we reported a comp of 6.4% in the second quarter. We know we had 20 basis points of pressure anniversarying Superstorm Sandy sales and then we think we got about 150 basis points of benefit from the seasonal business. So that would suggest then the run rate for the business is about 5%.

Excellent. And then just trying to tease out expectations for Q3 and Q4 a little bit more. Previously, you have articulated comps being in a pretty narrow range with Q4 comps, slightly ahead of Q2, but given the large outperformance in the second quarter here, maybe any updated thoughts?

Sure. The range will still be very narrow between Q3 and Q4. Q4 should be a higher comp quarter than Q3, but slightly under what we reported for Q2.

Great. And then one other question. The COM and the EDI just rolled out last quarter. I was wondering if you can give us an update and some of the early results and progress that you are seeing there.

We are very early on in the rollout of the program, but it is going well. We are excited about this technology enhancement, bringing enhanced visibility for our customers and our associates to special order programs. Consumers being able to get that update in terms of the status of their order based on how they want to receive it, whether that be text or email. So it will drive an efficiency in communication and it will drive greater visibility also for our merchants in terms of overall performance on special orders. So very pleased with the current status of how that is rolling out. Early days still.

Excellent. Thank you.

Scot Ciccarelli, Royal Bank of Canada.

Hey, guys. Understanding that certain expenses, Carol, like you pointed out, shrink and workers' comp, etc. will bounce around, is there a structural limit to your EBIT margins? Maybe a better way to say it is is there a point where your historical 20 bps of EBIT margin expansion per point of comp starts to break down?

Well, Scot, as you've seen, we continue to outperform our expectations on expense productivity. At the beginning of the year, we said our expenses would grow at 33% of our sales growth rate. We are now updating the guidance to 23% of our sales growth rate. Really because of what we have seen in terms of lower casualty reserves coming off of these great programs and workers' comp. As we would look to 2015 and beyond, it's our point of view today that expenses would grow more in that 33% of sales growth rate. It doesn't mean that we won't continue to focus on productivity because we will, but I would think for modeling purposes that is the number that I would use.

Got you. And then, Carol, you had talked about some mixed signals in the housing market and I know we've seen existing home sales a little bit softer than I guess what a lot of us would've expected. I guess maybe the question is what parts of the market are you most bullish about and then what parts are you maybe most concerned about at this stage? Thanks.

Well, as we look at the housing indicators, there are three that we pay attention to most closely. That would be turnover, home price appreciation and household formation. Turnover is slower than what some people had hoped for, but in line with our expectations, which is about 4% of units. Home price appreciation slower than some people had hoped, but in line with our expectations. For the year, we project home prices to be up around 5% or 6% and that is how they are trending. Household formation at 500,000 households is certainly below what all of us would like to see. We used that number when we built our plan, but clearly we'd like to see that improve because there is something like a third of the people who are aged 18 to 36 living at home with their parents. Something has got to move.

And so to your question what are you most concerned about, well, it is mortgage financing availability. There has been some modest movement. There was a survey of senior loan officers. 70% of them said that underwriting standards haven't changed. Well, that is better than last quarter where it was about 74% of them said that underwriting standards hadn't changed. But something has got to move on mortgage financing reform. So for us, we continue to pay real close attention to that.

Got you. Thanks a lot, guys.

David Schick, Stifel.

Hi, good morning and congrats on a very impressive quarter. Two things. So first, you mentioned that you have been changing communication with customers, making it more personalized. Any color you can give on results you are seeing real-time from that, whether it is a program that you turn on -- a specific program you turn on or a part of the store? So any of the efficacy of that?

And then second, sort of relatedly, you have mentioned the larger pro customers growing faster than pro overall, which I think you said pro overall was in line with the average. Is the large pro growth just due to the difference in the health of those customers or is it something you are doing specifically in targeting the larger pros, some work you are doing with them? Thank you.

I will take the digital marketing and then ask Marvin to talk about the pro. On the digital marketing, this has been something that we have been transitioning for a number of years now and trying to drive to greater efficiency. And I think specifically you have to look at the overall results of the business and we believe that this shift in how we have approached communicating with the customer is a piece of what has been driving our results over the past couple years. And so I don't think -- we don't focus on it necessarily category-specific. We have programs across the store that we utilize the digital approach with to really communicate with our customers virtually in every category.

This is an interesting data point. Print will be less than 10% of our total advertising spend this year while digital is 36% and trending higher and we like the return on investment that we see.

David, regarding the pro, we have been on this journey for quite a while and when we look at the larger pro, Craig mentioned that their performance outpaced the total Company. And we think it is a couple of things. Number one, as Carol mentioned, just access to capital and we think that these individuals, because they have larger businesses, just have a greater means to borrow and to grow their business. We also believe that the emphasis we placed on an outside selling force the last couple of years and we have approximately 200 plus individuals that work outside of the store and their primary responsibility is to go out and make sales calls on job sites, business locations and really sell The Home Depot as a value proposition to these larger customers. We think that that is gaining traction.

But also we think a lot of these smaller pros are in the depths of the housing recession, really exited the business and started to work for some of the larger pros. So we see some of our smaller pros as subcontractors so to speak that are supporting the larger pro business. So we think it's a combination of just a broader economy, but also some of the efforts we place on attracting these customers and providing them with a better understanding of the value proposition of The Home Depot.

Thanks.

Matthew Fassler, Goldman Sachs.

Thanks a lot, good morning and congratulations on a terrific quarter. My primary question relates to the role of credit in the store and how that ties into big ticket. What can you judge about the way the consumers are borrowing and paying for goods based on the tender that they use in the store and what kind of response are you seeing from your third-party provider on the private label credit side?

Yes, we are very pleased with what we are seeing within in our private label portfolio. The penetration increased by 57 basis points to 23.2% of total sales on our private label card. And as you would imagine, Matt, because we use our card as a financing tool and not a discounting tool, we see sales on that card for the larger ticket purchases. The portfolio itself is very healthy and that is good news too. So on the approval rates, we've seen our consumer approval rates up 182 basis points year on year with an average line of about $5,800 and on the pro side, the approval rates are up about 140 basis points. Now almost 72% of all pros who are applying for credit are getting approved with an average line of around $6,900.

Can you remind us, Carol, on sort of the direction of some of those numbers, the penetration, the approval rates, etc? Are those moving up and to the right continuously and did you see any kind of a stepchange here in the second quarter?

They are moving up continuously. It is a slow, steady move, if you will. No stepchange.

Got it. And then just a very quick follow-up. I know weather has come up a couple of times. If we take a step back from sort of the seasonal spillover and the 150 basis points that you mentioned, looking at a couple companies that retailers are the most weather-sensitive, some of them are of the view that the weight of weather on the business extended beyond some of the core seasonal categories and left it a bit deeper into the season i.e. perhaps into your second-quarter period and only would have really fully abated kind of in the June, July timeframe. Do you guys share that point of view or do you feel like the impact of weather was more limited and more directed to some of the categories that you specified?

We didn't see it. You can see with our numbers we really didn't see that.

Got it. Thanks so much.

Peter Benedict, Robert Baird.

Hi, guys. Thanks for taking the question. My question is really around your efforts to drive increased pro loyalty with Pro Xtra and some of the CRM stuff you are doing. Can you help us maybe frame the opportunity you see on that front? I think in the past you guys have spoken to your average pro doing around $6000 in spend a year. Help us understand what percentage of their wallet you think that is and where do you think you can take that reasonably over time?

Peter, this is Marvin. On the percent of wallet, that is a tough one. That is a tough data point to kind of vet out, but what we can tell you is that we are excited about Pro Xtra. We have approximately 1.7 million members signed up. We increased it up over 200,000 this quarter and that has been two consecutive quarters we have signed up in excess of 200,000 new members. And as a reminder, I mean this is just a unique play for us to create a program where customers can sign up and leverage the buying scale of The Home Depot to take on some opportunities in their business that they can't afford, things like satellite roofing for a small roofer. If you are small and independent, that is really an expense that you can't take on. We can allow them to kind of piggyback us.

We have also rolled out recently things like credit protection against any type of fraud. We have discounted background checks. So you name it, we have quite a few things. Even this week, if you want to sign up, we have a great offer. 25% off special order inside cabinets and countertops for pros in this program that is going on this week. So we have unique offers exclusively for these pros so that they can take advantage of some of the great benefits of shopping at The Home Depot. Very, very early days in this program. We are working with Matt Carey's IT team to make this a more robust program and we are excited about the possibilities.

And Peter, this is just math, but if we had either a 5% increase in our ticket or three more transactions per pro per year, it is a $1.2 billion opportunity.

That's terrific. Thanks, Carol and thank you, Marvin, for that. Carol, just to follow up on one thing you mentioned in your prepared remarks, the transportation costs being a headwind. We have heard that from some other folks. Can you maybe drill down a little bit more detail why are transportation costs up for you guys?

I would love to have Mark Holifield address that.

Yes, hey, Peter, Mark Holifield. We were pleased with the responsiveness of the supply chain overall during the quarter. It was pretty challenging with the rebound in seasonal weather, but unfortunately we did have to spend more to move our freight. The primary drivers of that really are what is happening on the rails with declining service there year over year, some of the new drivers of service regulations causing some driver shortage issues and then we saw freight market imbalances brought on by diversion of cargoes from the West Coast.

Okay, perfect. Thank you very much, guys.

Greg Melich, ISI Group.

Thanks. You mentioned the dotcom growth still very strong. Could you tell us what percentage of sales that made up in the quarter and do you think that growth you are getting there, is it all additive or is some of it cannibalistic from traffic you would've added any way to the stores?

Yes, dotcom sales made up 4.2% of our total sales at the end of the second quarter. That is up 100 basis points from a penetration perspective year on year. Hard to actually measure incrementality, but I would say Buy Online Ship to Store is 100% incremental. And that in the second quarter was $144 million.

Great. And then to follow up, you mentioned, Carol, I think in gross margin drivers, you hit some breakpoints and got vendor rebates. Would you expect to continue to have that level of benefit in the second half and then also what specifically caused the drag on shrink?

Sure. So to the impact of higher co-op and rebate in the second quarter, that was really a timing matter. If we look at where our purchases were in the first quarter versus second quarter, it is just a timing matter. Let me give you a better data point. If you look at the impact of co-op and rebate for the first half, it was a 3 basis point benefit.

Now in terms of shrink, you may recall last year we had 10 basis points of benefit from shrink in the second quarter and that reversed itself this quarter. There are three drivers of shrink effect, operational processes and system and accuracies. As you know, we put a lot of change into our stores, a lot of new processes and systems, Buy Online Ship to Store, Buy Online Pick Up In Store, Buy Online Return In Store and the list goes on. It is not uncommon when you have change inside of the store to see both shrink and swell and that is what we are experiencing. We have got a team that is working on this and this will be an issue that goes way over time. We have just got to work through it.

Yes, and Greg, this is Marvin. We are very confident in the processes and programs we have in place. We have one of the best analytical focuses on shrink reduction that I've seen of any retailer and it's a cross-functional effort with the merchants, with the internal audit group, with IT and operations. So to Carol's point, there's a lot of ins and outs. We have had unprecedented process changes and systems changes the last three years, but we are very confident and comfortable with our focus and we believe that we will continue to get that number down.

That's great. Thanks a lot.

Michael Lasser, UBS.

Good morning. Thanks a lot for taking my question. I wanted to ask about the connection between the outdoor categories in the second and third quarter. Is there any possibility that, given the extended season, where it was cool in July and you reported a really strong comp during that month, that that could draw away some potential sales from the fall because consumers may have been able to do projects like exterior paint in the summer where they might have been waiting for the fall or alternatively they maintain their lawn and garden much further into the season this year and so they may have a little less cleanup than they might have in the past?

We really don't see it that way, Michael. If you think about kind of typical projects that customers do spring and then in the fall, they are very different. So in the spring, you are actually getting your beds and stuff ready to plant for the spring season. That then transitions to a whole new planting cycle in the fall and the absolute best time to plant any kind of shrubs and trees and so on is in the fall time frame so that you are moving away from the heat. I don't think that changes. Fall cleanup is a big element that drives in the fall timeframe as well. That is obviously going to happen. I do think we have benefited from the fact that it did not move from winter to 95 degree heat straight out of the blocks. That helped us in terms of people maintaining their yards through the summertime, but don't see that as a drag in what customers typically do in the fall.

Okay, my second question is on some of the merchandising activities that you did with the clustering and the tools and you cited the example of water heaters. If you could size the percentage of your sales that have now been touched by the increased analytics and more sophisticated analytics that you are using to give a sense of what the future opportunity might be?

We are very early on. We have just begun on the new tool enhancements to begin to review categories in this process. We typically review roughly a third of our categories per year. So you are here in the early innings of a three-year cycle first go-around and then we will learn from that process as well.

And on water heaters, do you ascribe a big portion of the comp outperformance to some of the activities that were done?

Definitely. We definitely did a much better job of utilizing our clustering capability and identifying the opportunities where we could put a more productive assortment into specific stores.

Okay, thank you very much. Good luck with the rest of the year.

Dennis McGill, Zelman & Associates.

Good morning and congratulations. As you look at the comp in June, domestically at least, the comp in June versus July, that acceleration, was that also across the store kind of consistent with the message for the quarter where there wasn't a whole lot of variance across categories?

Yes, it's pretty consistent.

Okay. And then, Carol, with respect to appliances, the strong growth this quarter, if I'm not mistaken, the year-ago appliance growth was maybe the best of the year and very robust. And just curious what you're looking for in the back half of the year as far as benefit from comp or the ability for comps to maintain this double-digit pace?

Our expectations for the appliances in the back half of the year are contained in the guidance we just shared with you.

Okay. Well, since I didn't get that one, I will ask another one. On the outdoor garden, any specific numbers that you can put behind that as far as how far above average it was?

It was more than 100 basis points.

Yes, more than 100 basis points, yes.

Perfect. Thanks again.

Jaime Katz, Morningstar Equity Research.

Good morning. Thanks for taking my questions. I am curious about your outlook for capital allocation strategy. Is there still some free cash flow to be spent longer term? I'm wondering if you guys think about either raising the dividend or paying down some of the higher rate debt and after that, maybe a little bit more color on Mexico and Canada please.

Yes, from a capital allocation philosophical perspective, the first use of cash is to invest it back in the business and this year, we have a capital plan of $1.5 billion and we are committed to that plan. Interestingly, we are tilting our investments more towards interconnected retail and technology as we continue to try to meet the needs of a changing customer.

The next use of capital is for our dividend. We have a 50% payout target, which means, at the end of every year, we will look back to see what we earned. We will cut it in half and that will be the new dividend. If we were ever to have an earnings disruption, it wouldn't be our plan to cut the dividend; we would just earn back into that 50%. Longer term is 50% the right target? Perhaps it should be higher, but right now we are at a 50% target.

And then we use excess cash to buy back our shares. We will use debt capital to buy back our shares if we think it is value-creating. As you saw, we raised $2 billion in June of this year. The after-tax cost of that debt was 2%. The yield on our stock was 2.3%, so we thought that was a great trade. And we will continue to look for opportunities like that.

And Jaime, on your question on Canada and Mexico, as I indicated, we are very pleased with the results in both countries. Canada benefited from the same weather and seasonal rebounding that the US business did and had very strong comps. Mexico is doing very well and has been doing very well for many, many years. The only kind of interesting curiosity on the results in the quarter was that they were impacted by the World Cup. We could actually see the dividend sales when Mexico was playing in World Cup matches, but they still performed very well.

Excellent. Thank you.

Mike Baker, Deutsche Bank.

Hi, just one or two follow-ups. On the appliances, you said the jumbo set is in 800 stores; it's going to be in another 183 by year-end. Can you just sort of remind us where it was a year ago, where it began the year, those types of measurements so we can sort of get a sense as to the year-over-year change in the number of stores that that is being put into?

Well, Michael, first, when I said the expanded assortment of appliances, we have jumbo, we have jumbo lights, we have Bigfoots. We have various themes of the merchandising display within our store. So I just wanted to make that clarification. A year ago, we were probably 250 stores less than where we are today.

Okay. And so that's the type of -- where did you end the year? Or start this year?

About 250 stores.

I will get back to you on the exact store count. Sorry, don't have it with us.

Okay, fair enough. One more then if I could? SG&A in the back half, are there any other -- so will incentive comps continue to be a benefit to you and are there any things like that legal settlement that we should know about that occurred in the back half of last year that wasn't necessarily called out on the call last year?

No, I think what I said in my prepared remarks is that our total expenses we now forecast will be under our plan year on year and that is because of really for the most part lower casualty reserves.

Okay, understood. Thank you.

Keith Hughes, SunTrust.

Thank you. Switching back to the services, which has done so well in the quarter, give us a feel for how big of a business that is now and specifically which services are doing well of late?

So roughly about 4% of our total sales comes from our services businesses today and we saw a real strength across HVAC, windows, water heaters. So a lot around both maintenance and repair, as well as the millwork space.

Thank you.

Audra, we have time for one more question.

Eric Bosshard, Cleveland Research Company.

Thanks. You commented that the first half in total, 1Q plus 2Q, was similar to what you had thought it might be coming into the year, but it seems like July and August are probably better or perhaps materially better than you might have thought coming into the year and it doesn't sound like it is weather or seasonal. Could you just give us again the insights into what is driving the business in July and August despite the macro housing indicators not being as great as one might have hoped?

Eric, it is really strength across the store. As I mentioned, we've seen pretty tight performance with the lowest department being north of a 4% comp. We've seen strength across maintenance and repair, we've seen strength across decor businesses and clearly, we had the rebound in our seasonal businesses as well. When you've got a pro reengaged, they shop across our store and it's great to see customers investing in their homes and it's great to see them doing projects, as Carol mentioned, in our services business. That is a big-ticket spend; it is $1500 plus on average. So we are very, very pleased with the breadth, if you will, of the performance both from a category standpoint, as well as a geographic standpoint.

When you look at that and think about planning the back half of the year either in terms of inventory or promotion or mix or even expanding categories, any influence on how you are managing the business in light of what you are seeing?

Honestly, the plans for the back half of the year have been put in place months ago. We always would tweak and make adjustments, but the heart of what we've got planned was committed many moons ago.

Our holiday buy was made last year.

Because we have to make those buys well in advance.

Right, yes.

Thank you.

Well, thank you all for joining us today. We look forward to joining you on our next quarterly earnings call.

That does conclude today's conference. Again, thank you for your participation.