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Operator
Good morning, everyone, and welcome to Lowe's Company's third quarter 2004 earnings conference call.
This call is being recorded.
Statements made by management during this call may include forward-looking statements as such are provided for by the Private Securities Litigation Reform Act of 1995.
Although the company believes the expectations, opinions, projections, and comments reflected in such statements are reasonable, it can give no assurance that they will prove to be correct.
A wide variety of potential risks, uncertainties and other factors could materially affect our ability to achieve these result, expressed or implied by the forward-looking statements and those risks and uncertainties detailed in the company's earnings release and other filings with the SEC.
Hosting today's call will be Mr. Bob Tillman, Chairman and CEO;
Mr. Robert Niblock, President,; and Mr. Robert Hull, Executive Vice President and CFO.
Please note the call will conclude promptly at 9:45 a.m.
Eastern time.
I will turn the program over to Mr. Tillman for opening remarks.
Please go ahead, sir.
- Chairman, Chief Exec. Officer
Good morning and thank you for joining us.
Following my remarks, Robert Niblock will assess our operational and merchandising performance for the quarter and Bob Hull will review our third quarter financial results.
But first, I will brief briefly highlight a few items from the quarter.
Total sales increased 16% to $9.1 billion in the quarter, and comparable store sales increased 5.2%.
Our sales performance on top of the most difficult comp sales comparison we've faced in nearly a decade is a clear sign of the strength of the home improvement consumer, as well as our success in achieving our vision of being our customers first choice for home improvement in each and every market we serve.
Earnings growths of 15.5% and earnings per share growth of nearly 18% to 66 cents also against tough year-ago comparisons continue our record of strong and consistent growth in earnings.
We continue to make investments in our business including over 400 million in updates to our existing stores and 300 million in technology.
All to ensure we continue to evolve with our customers' ever-changing needs, providing the service they expect, the products they desire, and the best stores in the industry in order to maintain our competitive advantage.
Many signs point to continued strength in the home improvement industry.
In the near-term, signs of an improving employment picture are encouraging.
As more Americans are actively employed or are confident they will remain employed, consumer confidence will likely improve and consumer spending should follow.
And over the longer-term, the picture for the industry remains bright as well.
Faded by record home ownership, historically low interest rates and over 35 years of consistently increasing medium home values housing turnover remains at record levels as American consumers continue to focus on their homes.
With current social and demographic trends providing a solid foundation, housing turnover is expected to grow to another record in 2004.
Beyond that, I am confident that demographic and cyclographc trends in the U.S. will support our growth and the growth for the home improvement industry for many years to come.
Now here's Robert with a detailed look at the initiatives that continue to drive our solid performance.
Robert?
- President, Director
Thanks, Bob.
The performance our stores delivered in the third quarter and really for the past several years is a true mark of consistently.
This quarter marked the sixth consecutive and seven of the last eight quarters where we delivered a double-digit two-year comp.
Said another way, our stores are delivering strong sales results on top of strong prior-year sales.
In fact, our 5.2% comp this quarter on top of our 12.2% comp in the third quarter of 2003 represents our best two-year performance in nearly a decade.
Our performance is driven by great customer service, a compelling product offering, and solid execution in our stores.
I think these results also speak to the strength of the home improvement consumer that Bob mentioned.
And with many signs suggesting continued strength, we're confident about the future.
But even with our solid performance, we're always looking for ways to improve our offering to our customers.
That's why we continue to raise the bar, even when things are going well to ensure that we deliver better performance in the future.
In order to deliver comps in 2005, we'll continue to fine-tune our product offering, improve our service and enhance the customer experience in our stores.
In the third quarter, we continue to see strong growth in average ticket as we sold more complete projects, grew our installed sales, SOS and CBC businesses and saw the continued success of our up to continuing merchandising strategy.
We also experienced improving trends in customer traffic in the quarter.
Up against tough year-ago transaction counts, comp traffic was slightly positive versus the third quarter last year.
And we're confident that our merchandising, marketing, and operational strategies will lead to continued improvement in these trends.
Consistency was also apparent in the performance we saw across our product categories.
For the third quarter, 16 of 18 product categories delivered positive comp sales.
Two categories showing particular strength in the quarter were outdoor power equipment and cabinets and countertops.
These two large-ticket categories posted strong double-digit comps, evidenced of a great product offering and great in-store service but perhaps most importantly, these results are a clear sign that the home improvement consumer remains willing to invest in their home.
And up against tough year-ago comparisons, we saw improving trends in our appliance category during the quarter, delivering a high, single-digit comp in October.
Our tool category also posted high single digit comps for the quarter, driven by remerchandising efforts this year to open our Tool World area to improve the shopping experience for customers.
We also saw strong regional performance with 18 of 21 regions delivering positive comps and the remaining three regions being only slightly negative.
Given the tough comparisons we faced from last year's third quarter, I'm pleased with these results.
But again, there are certainly areas for improvement.
Many of which we're already addressing in order to drive comps in the future.
All in all, monthly comps were generally consistent across the quarter with each month delivering a solid mid-single digit comp sales increase.
As most of you are no doubt aware, we did experience some incremental sales benefit from the series of hurricanes that hit Florida and the Gulf Coast during August and September.
Offset to some degree by the impact of being closed during the passing of these storms, incremental hurricane-related sales are primarily lumber, building materials and other preparatory or cleanup items, aided comp sales in the quarter.
But an important thing to remember when measuring how those incremental sales flowed to the bottom line is the mix of products sold.
The fact that the lift in sales was driven by commodities like lumber and building materials and low margin products like roofing and generators, combined with our corporate policy of instituting a price freeze in markets impacted by natural disasters, meant that our gross margin rate was negatively impacted for hurricane-related sales.
In addition, we faced increased expenses as we worked to flow additional product to affected areas, brought in additional staff to handle the increase demand, and repaired the damage our own facilities encountered as a result of the storms.
But, judging from past experience, these margin pressures are only temporary.
While lower margin products like roofing materials remain in high demand, following these types of natural disasters, we typically see an extended sales impact as customers take on projects that involve more of the decor categories, as they move past the preparation and recovery mode and look to get their lives and homes back to normal.
While less than 10% of our total store base was affected by these storms, we continue to see strong demand in the Florida and Gulf Coast regions and our stores are ready with the products and services that customers need to repair their homes and businesses.
On the expansion front, we continue to open stores around the country and we're pleased with the acceptance we're seeing in new markets.
New store productivity remains high and we're confident as the opportunities that lie ahead for both our small market 94-K prototype and our large market, 116,000-square foot store.
We open -- we'll open 56 stores in the fourth quarter.
The most we've opened in any single quarter.
Our project teams are prepared for these openings.
We have well-trained and energetic employees ready to serve customers in each of the markets and we will remain on track to open 140 new stores in 2004.
Now, an update on a few initiatives.
Our improved installed sales model continues to roll out across the country with the new model scheduled to be in all stores by the end of this fiscal year.
We continue to see strong acceptance among customers, installers and employees and with the rollout behind us, our performance in this high-growth area will continue to improve.
Our special order sales initiative continued to perform well, posting comp sales well above the company average.
Our SOS express initiative and fashion plumbing is a great example where advances in technology have improved the product selection process, order entry and lead times, making a special order much more customer-friendly than in the past.
Similar plans are being developed for other categories, which will serve as drivers of special-order sales in future years.
We continue to gain traction with our commercial business customers.
Our national expansion is making more stores, more convenient for more customers and our successful efforts to ensure we're in stock with job lot quantities each and every day is resulting in more commercial customers making Lowe's their first choice.
CBC comps significantly outpace the company average in the third quarter, continuing a year-long trend for this area of our business.
I would also like to update you on our rapid response replenishment, also known as R-3 distribution initiative.
As Michael Mabry described at our recent analyst meeting, he and his team has identified ways to reduce lead time and variability of shipments through our RDC network and drop in-stock levels in our stores.
In summary, we're working to ship more products to our DC network and increase the frequency of DC deliveries to our stores with a goal of at least a truck per day to each of our stores.
As part of this process, we'll move safety stock out of our stores and hold that safety stock in our DC network.
With at least a truck a day going to each store, we'll be able to quickly and efficiently flow product to stores and the quantities necessary to support sales demand.
In order to maintain our service levels, we have taken a conservative approach in implementing these changes by adding inventory to our distribution network before pulling it out of our stores.
As a result, inventory growth slightly outpaced sales growth in the quarter as we increased DC inventory levels by approximately $200 million in order to implement this strategy.
As we start removing safety stock from our stores, we expect to begin seeing the benefits of those changes early next year in the form of inventory leverage and inventory turn improvements.
Perhaps the best evidence of the value of our centralized distribution system is found in the way we were able to react to the four hurricanes that hit the southeast during the quarter.
We have invested over $1 billion in the network that allows us to flow products to affected areas, which experience flux in demand sufficiently keeping stores in stock, serving our customers and creating a significant competitive advantage.
Customers across the country benefit from the network strength and flexibility every day, but I'm certain our customers in the southeast had access to emergency products, quicker than they otherwise would have thanks to our state-of-the-art distribution infrastructure.
I'm confident the results our stores generated in the third quarter are a clear seen our internal initiatives to serve our customers and drive profitable sales are working.
A relentless focus on improving all areas of our business allowed us to deliver strong comps against tough prior-year comparisons.
These results clearly represent the ongoing strength of the home-improvement consumer ,a strength we're optimistic will continue.
Ill now turn it over to Bob Hull to discuss the financial highlights of the third quarter.
Bob?
- Chief Financial Officer, Sr. Vice President
Thanks, Robert.
And good morning, everyone.
As Bob indicated, sales for the third quarter were $9.1 billion representing a 16.2% increase over third quarter last year, ahead of our 15% guidance.
Year-to-date sales increased 18.3% to $27.9 billion.
Comp sales were 5.2% for the quarter, which exceeded our guidance of 3 to 4%.
Sales for the quarter were positively impacted by the four hurricanes that hit Florida and the Gulf Coast in the quarter, which aided comp by approximately 100 basis points.
Last year, our third quarter comps were 12.2%.
The 12.2% figure represents sales from continuing operations and excludes the positive 20 basis-point impact on the contractor yard locations that were sold at the end of last year.
Looking at the two-year comp trend, our performance this quarter represents our strongest since the first quarter of 1995.
Year-to-date, comps are 6.6% on top of 6.5% comp for the first three quarters of 2003.
Inflation in lumber and building materials resulted in a favorable impact on third quarter comps of approximately 150 basis points, driven primarily by lumber and plywood.
With regard to product categories, the categories that performed above average in the third quarter include rough plumbing, building materials, rough electrical, tools, hardware, outdoor power equipment, flooring, seasonal living, and cabinet countertops.
In addition, new work, lumber and home organization performed at approximately the overall corporate average.
Gross margin for the quarter was 33.7% an improvement of 237 basis points over last year's third quarter.
As required by emerging issues task force or EITF 0216, we are request by our vendor reimbursements for co-op advertising and in-store service from SG&A to cost of goods sold.
This change increased gross margins 307 basis points in the quarter.
The hurricanes had a negative impact on our gross margin rate.
The impact of product mix, additional freight costs and damage inventory per gross margin by approximately 15 basis points in the quarter.
In the third quarter, our gross margin was also negatively impacted by an increase in distribution costs.
In September at our analyst and investor conference in New York, we described the enhancements we were making to our logistics and distribution model.
This included adding safety stock to our distribution centers, testing now programs, reconfiguring racking and training employees.
Those initiatives are causing a temporary increase in our distribution cost but with a longer-term positive implications for our in-stock position, inventory productivity and SG&A leverage.
In the third quarter, inventory shrink was approximately flat last year.
Year-to-date gross margins of 33.4% is up 245 basis points over fiscal 2003.
The year-to-date EITF 0216 impact on gross margin was 249 basis points.
SG&A deleveraged 240 basis points in the quarter, driven primarily by 299 basis points of EITF 0216 impact associated with the reclassification of vendor reimbursement I mentioned a moment ago.
In the third quarter, absent the impact of EITF 0216, we leveraged SG&A by 59 basis points, this is driven by our credit portfolio performance, bonus expense and numerous other expense lines.
In addition, in the third quarter, we incurred incremental expenses as a result of the hurricane, these expenses for overtime, repairs, and trash removal associated with the storms added approximately 5 basis points to SG&A for the quarter.
Also, SG&A for the quarter includes $20 million of stock option expense, compared with $13 million in Q3, 2003, which caused five basis points of SG&A deleverage for the quarter.
Year-to-date, SG&A is 20.5% of sales.
Operating margin defined as gross margin less SG&A and depreciation was 10.2% of sales, a decrease of 6 basis points over Q3, 2003.
The EITF 0216 impact in operating margin was a positive eight basis points, which is calculated by taking the difference between a 307-basis point increase in gross margin and the 299 basis point increase in SG&A.
The EITF 0216 impact gross margin SG&A net income and diluted earnings per share is provided via the pro forma statement included in our earnings release.
For the year, operating margins is 10.5%.
Without the impact of EITF 0216 and the hurricanes, third quarter operating margin would have been up slightly to last year.
Store opening costs at $32 million leveraged 12 bases points the last year as the percent of sales and reflect the opening of 35 stores including one relocated store in the quarter.
This compares to 38 stores including two relocations last year.
Depreciation at 2.5% of sales totaled $226 million and deleveraged three basis points.
This deleverage was caused by our store expansion program and a continued investments we're making in resisting stores and technology that Bob referenced.
At the end of the third quarter, we owned 80% of our stores versus 78% at the end of Q3 last year.
Interest expense totaled $40 million for the quarter and leveraged 10 basis points as a percent of sales.
For the quarter, total expenses were 24.3% of sales and deleveraged 221 basis points, which is driven by the reclassification of vendor reimbursements to gross margin.
Without EITF 0216, total expenses would have leveraged 78 basis points.
Year-to-date total expenses are 23.6% of sales.
Pretax earnings are 9.4% of sales for the quarter, up 16 basis points over the prior year.
For the year, pretax earnings of over $2.7 billion are up 18.4% from 2003.
The affective tax rate for the quarter was 38.7% versus an affective tax rate of 37.8% for Q3 last year.
Year-to-date, the effective tax rate of 38.5% compares with 37.8% for the same period last year.
Diluted earnings per share of 66 cents increased 17.9% verses last year's 56 cents.
For the first nine months of fiscal 2004, diluted earnings per share were up 14.7% over 2003.
Without the 16 cent EITF 0216 impact, diluted earnings per share would have increased 23.4% in the first three quarters of 2004.
While the hurricanes positively impacted sales by approximately 1% for the quarter, the negative gross margin in SG&A impact I mentioned a moment ago reduced operating margins.
This explains why we exceeded our sales guidance by 1.2%, yet only hit the top end of our earnings guidance.
Diluted shares outstanding averaged 792 million for the quarter, the computation of diluted shares takes into account the effect of convertible ventures which increased third quarter weighed average shares by 16.5 million.
In computing third quarter diluted earnings per share, the after-tax added back net income for interest on convertible ventures was $2.6 million.
For the fourth quarter, the after-tax interest add back is also $2.6 million and were projected diluted shares outstanding of 796 million.
For the year, we're projecting diluted shares outstanding of 798 million.
In Q3, average tickets grow from $60.27 to $63.72, an increase of 5.7% and customer count increased approximately 10%.
Comp customer count for the quarter was up slightly to last year.
Now, to a few items on the balance sheet.
Cash and cash equivalence for the quarter totaled almost $500 million.
Inventory turnover was 4.45, a decrease of six basis points from Q3, 2003.
The distribution initiatives I noted a moment ago added approximately $200 million in inventory in the quarter, contributing to the decline in inventory turnover.
Our debt to capital ratio is 25% at the end of our third quarter, down from 27% from the same period last year.
Return on investment capital measured using beginning debt and equity and the trailing four quarters earnings was 16.1%, a decline of six basis points to Q3 last year.
Return on assets, determined using beginning total assets and a trailing fourth quarter earnings was 11.2%, representing a decline of 14 basis points.
Without the $127 million reduction in net income associated with EITF 0216, return on investment capital and return on assets would have increased 87 and 54 basis points respectively.
Year-to-date cash flow from operations exceeds $2.1 billion, driven primarily by increased earnings.
Looking ahead, I would like to address several of the items detailed in Lowe's' business outlook.
Our fourth quarter sales increase of 16 to 17% incorporates a cost assumption of 4 to 5% which is expected to generate diluted earnings per share of 58 to 60 cents, representing an increase of 14 to 18%.
For the year, we're estimating a comp sales increase of 6 to 7%.
Operating margins for the fourth quarter is expected to decline approximately 10 basis points to last year.
For the entire fiscal year, we're anticipating an operating margin decline of 25 to 35 basis points attributable to the estimated 60 basis-point impact from EITF 0216.
In the fourth quarter, we expect to open 56 stores with no relocations and store opening costs of $52 million.
We are still on track to open 140 stores for this year.
The tax rate for Q4 is expected to be 38.5%.
The tax rate for the year is also expected to be 38.5%.
For fiscal 2004, we expect diluted earnings per share of $2.69 to $2.71.
Our fourth quarter and 2004 guidance does not include the impact of EITF 04-8, which deals with contingently convertible debt instruments.
The FASB has ratified issue 04-8 with an expected affective date of a reporting period ending after December 15, 2004.
Once the effective date is official, our October 2001 convertible debt offering will be deemed dilutive since its inception, which would retroactively add 10 million shares to our diluted share count and would reduce annual earnings by approximately 3 cents per share in 2004, two cents per share in 2002 and 2003, and 1 cent per share in 2001.
Regarding current sales trends, I mentioned earlier that our business outlet for the third quarter anticipates 4 to 5% comps.
For the first 16 days of the quarter, our comps are at the top of the range.
On October 8, Moody's revised their rating outlook on Lowe's from stable to positive.
All three rating agencies currently have Lowe's on positive outlooks.
Lastly I wanted to make you aware of a change in our Q4 reporting schedule.
Since Presidents' Day will be observed on Monday, February 21, 2005, we will report our fourth quarter results and hold our conference call on Wednesday, February 23rd.
Before I turn the call over to the operator for questions, I would like to mention that in addition to Bob, Robert and myself, Larry Stone, Dale Pond, and other members of our management team are present for the question and answer session.
Lynn, we're now ready for questions.
Operator
In order to allow questions from as many individuals as possible, please limit yourself to one question.
If you have a question at this time, please press star and then the number 1 on your telephone keypad.
Your first question comes from Greg Malitch with Morgan Stanley.
- Analyst
Hi, thanks guys.
Question on the inventories.
The 200 million got added for this.
If you look out a couple of years, how much inventory do you think you can take out of the stores as a result if you do this right and then related to that, how does it impact the gross margin SG&A balance?
This is the sort of thing that going forward it sort of could help on you markdowns but hurt you on SG&As.
Just help us to think that through.
- President, Director
Hey, Greg.
This is Robert Niblock.
We haven't given any firm numbers as far as to how much we think the R-3 initiative will be able to take out of the system going forward, but certainly we would anticipate being able to pull more out of the system than we put in the system.
So certainly as we go into the first part of next year, we would anticipate pulling more than the $200 million out of the system, and then we have other initiatives we'll work on behind that to -- that could have some additional improvement on top of that.
So -- so, certainly there are several things we're working on, we're taking a disciplined approach on it.
As I mentioned in my comments, you know our number one goal is to make sure we maintain our service levels and you know making sure as we're making the changes to the distribution network, stores have, the stores have the confidence out there that when we start pulling down their individual inventory levels, that the product will be replenished in a timely fashion to make sure that we do maintain those service levels.
Yes, as you start flowing more product through the distribution center, certainly that's, that helps you better leverage the cost of that facility so that has some impact on gross margin, a few basis points should be picked up there, and then on the SG&A side, as we've talked about in the past, we use good faith receiving in the product that comes in from our distribution center.
So, certainly, you will be able to get some efficiencies of receiving more product from our distribution on network, getting that product coming in, flowing more efficiently into the stores certainly some should help in being able to possibly reallocate some labor hours from what is receiving time over to maybe other areas of the store.
So certainly there ought to be a few basis point pick up.
But the real goal here is really being able to maintain those in-service levels, hopefully even flowing more through the distribution center, maybe reduce some of the damage we see otherwise coming in and save some time from the store standpoint of being able to receive that product.
But as far as going out and throwing out hard numbers and quantifying it, that's not something we have done.
We're taking this thing one step at a time and we're not going to throw anything out there forcing us to try and move faster than we think a disciplined approach would make sense on.
- Analyst
So from a timing perspective we should expect see it in the first half of next year?
- President, Director
Yes, you should, you should start, we'll start, actually, just the last couple of weeks of this year, start on a couple of product categories, pulling a little bit of inventory on the of the stores and the balance of that will occur over the first two quarters of next year.
- Analyst
Okay.
Great.
Thanks.
Operator
Your next question comes from Matthew Fassler with Goldman Sachs.
- Analyst
Thanks a lot and good morning.
Just a couple of quick questions.
Following up on the distribution initiative, Bob would it be possible to quantify the impact of those incremental distribution costs on gross margin in the third quarter in?
- Chief Financial Officer, Sr. Vice President
Sure, Matt.
That had about 10 basis point negative impact on the third quarter.
- Analyst
Got you, you know, if you look at 15 basis points or so of gross associated with the hurricane, you look presumably at some drag from the incremental lumber sales just generally speaking on the mix, and then you look at distribution.
It sort of adds up, you know, to something in the neighborhood of you know call it 40, 50 basis points, which would imply that when you back all of those out, the gross margin is kind of flat to slightly down, ex EITF.
I guess my question is if you think about your merchandising initiatives away from those environmental factors and away from the distribution investment, um, do you think that the company's still on a trajectory of rising gross margins from internal initiatives, vendor concessions, et cetera?
- Chief Financial Officer, Sr. Vice President
Yes, Matt.
I think we are still very confident that in 2005 and beyond, we can grow operating margins of 25 to 30 basis point.
- Analyst
Would you say that the gross margin piece of that is going to be a source of that increase or should we look for more of that from the SG&A front?
- Chief Financial Officer, Sr. Vice President
I think it will be fairly equal balance between gross margin expansion and SG&A leverage.
- Analyst
Got you.
Just a second, quick question.
On lumber prices, you know they clearly helped you again this quarter, and some of that was pricing and I guess some of that was mix.
I know the spot market has traded down a bit.
And I'm just wondering what kind of lumber price forecast, what kind of lumber contribution you think about as you contemplate your fourth quarter guidance?
- Chief Financial Officer, Sr. Vice President
When you look at the spot markets today compared to the average for Q4 last year, plywood today is down about 26% and lumber's about flat.
When you factor in the mix of the business, the lumber business, um, has a lower mix and total business, excuse me, about 200 basis points in Q4.
When you factor all of that together we think it could have a negative impact of about 25 or so basis points on Q4 comps.
- Analyst
So when you actually think about it, ex lumber, it looks like your comps -- your forecast action has a little bit of acceleration from the third quarter.
- Chief Financial Officer, Sr. Vice President
I'm sorry, could you repeat that?
- Analyst
Yes, you know, you did a 5 Q with 150 bases points of lumber, ex-lumber, if you will.
You -- you know you call it 3-7.
It sounds like you think you're going to be 4 to 5 and that's despite a lumber decline.
So it sounds like the base business is staying quite confident and maybe even a bit better if you back out commodity pricing.
- Chief Financial Officer, Sr. Vice President
Yes, that is true.
- Analyst
Got you.
Thank you very much.
Operator
Your next question comes from Michael Baker with Deutsche Banc.
- Analyst
Hi, thanks, guys.
Could you maybe comment on the, some of the advertising initiatives that you spoke about last quarter?
I think there was a little bit of confusion, were you in fact lowering prices or just advertising lower prices more than you had in the past, and what kind of impact you have seen, is that something that helped you post a slightly positive comp on your transaction accounts?
- President, Director
Yeah, Mike, this is Robert Niblock.
I will make a couple of comments and Dale Pond is in the room.
So I'll turn it over.
Just overall, you know on the advertising front, we are still seeing a very competitive situation out there from both gross advertising as well as some of the, you know, no interest, no payment promotions that are out there in the marketplace.
So certainly we're continuing to be ver -- be aggressive in those regards both on both of those initiatives.
And as mentioned, talked about at analyst conference, the new lower price program that we have out there really what we have in place now is the ability to systematically manage to see price charges as we make those, as we work with our vendors, negotiate better prices and as we decide to pass those prices along to our customers, we now have the ability to, um, manage that through more of an automated system and being able to highlight those new lower prices to our consumer both in the tabs as well as through in-store signage, and, um, so but not a whole lot of difference from, you know, what our policy has been all along in the past which, is being everyday low-cost retailer, to, when we have the opportunity, to be able to drive those costs down and take it, the benefit to the consumer to drive incremental sales.
I'll see if Dale has anything he wants to add to that.
SO--
- Senior Executive Vice President - Merchandising/Marketing
No, not really.
I mean that about covers it.
- Analyst
Great, thanks.
And if I could do one follow-up just on the fourth quarter guidance wise, the operating margin planned down, doesn't sound like it's an impact from EITF.
- Chief Financial Officer, Sr. Vice President
Mike, this is Bob Hull.
A couple of factors.
Number one we expect to have again negative mix impact in Q4, 10 or so basis points.
We had great trend performance in Q4 last year, that ought to hurt us about five basis points.
In addition, with the increase in owned stores, and our investments in the business, the depreciation should deleverage about 10 basis points in Q4.
- Analyst
And what's the mix impact as lumber is going to be less than it was a year ago, I thought.
- Chief Financial Officer, Sr. Vice President
Lumber will be less of an impact in Q4.
But there will be more lower margin categories associated with the recovery in the southeast, some of that building materials related.
The other key driver in the fourth quarter will be outdoor power equipment as well.
It's a key factor to that
- Analyst
Great.
- Chief Financial Officer, Sr. Vice President
impact.
- Analyst
Thank you.
Operator
Your next question comes from Dan Wheeler with CIBC World Markets.
- Analyst
Robert, looking at the timing of the hurricanes and when the insurance checks were processed, do you think that the impact on comp sales growth and margins will be better in 4 Q than it was in 3 Q and then separately, I noticed that the accounts payable are growing slower than inventories?
And you know besides the slowing inventory turnover, what else could be contributing to that?
Thanks.
- President, Director
Really as far as, we couldn't anticipate the hurricane impact to be greater in the fourth quarter than if the third, Dan.
I mean certainly you have a tremendous amount of activity going on right around that hurricane, both for the preparations for the hurricanes coming in and then the immediate recovery afterwards and then there is a longer tail on some of the other areas of the business.
So while we're continuing to see strong performance out of those areas of the country, we woould't anticipate anything greater than what we saw in the third quarter.
And your other question was?
- Analyst
The payable to inventory ratio looks like it may have slowed.
Is that due exclusively due to the slower inventory turns?
- President, Director
Yeah, that's really due to slower inventory turns.
And of course we had the issue where we are building the inventory in the distribution network.
I'll see if Bob Hull wants to add anything on top of that.
- Chief Financial Officer, Sr. Vice President
That's right, Robert.
Dan, when you look at the performance in the quarter, the inventory productivity, we actually had about two days more inventory in hand than we did Q3 last year, and our days payable outstanding didn't change.
So the additional inventory was the key driver.
- Analyst
Great.
Thank you.
Operator
Your next question comes from Budd Bugatch with Raymond James and Associates.
- Analyst
Good morning, this is Rex Henderson filling in for Budd today, who is on the road.
A couple of quick questions.
First of all, will the -- you mentioned that price freezes on commodity goods in the southeast in the hurricane affected areas affected gross margin.
Will that continue or is that over for now?
- President, Director
That's currently over, Rex.
We normally lie down prices for a period of 30 days after the event.
So, so those, all of those have, um, timed out at this point.
- Analyst
Okay.
Of course, we have a particular interest in -- down here in Saint Pete and Tampa on that issue.
The other, the other question I had for you was there was talk about, um, suppliers trying to pass through some price increases in the last quarter.
I'm wondering what you're seeing on that front.
Are you still seeing pressure or has that abated to some degree?
- Senior Executive Vice President - Merchandising/Marketing
Rex, this is Dale Pond.
We are, we are seeing some pressure on that and for the most part, though, we're not taking price increases.
On occasion, there are some legitimate and difficult to ignore raw material costs that affect our vendors, and when that pressure simply gets unbearable, um, and they put forth a pretty compelling case, we typically accept the increase but that triggers the line review where we, where we explore alternative sourcing to both domestic and offshore, and then we accept the increases only when they're tied to commodity indexes.
So if the price of steel or fuel, let's say, decreases, so do our costs.
- Analyst
Okay.
- Senior Executive Vice President - Merchandising/Marketing
And then we continue to work with our logistics group, obviously in trying to find better ways to forecast our needs, smooth the demand and flow the product more efficiently as well, so, there have been some, but they're few and far between at this point.
- Analyst
Okay, can you give me an idea what categories?
Is it resin-based products?
Steel-based products?
Where what areas are you seeing it?
- Senior Executive Vice President - Merchandising/Marketing
I would say steel and resin are both two of the primary drivers, yeah.
- Analyst
Any others?
- Senior Executive Vice President - Merchandising/Marketing
There's some copper costs that have affected costs of brass for example.
- Analyst
Okay.
Thank you very much.
Operator
Your next question comes from Eric Bosshard with Midwest Research.
- Analyst
Good morning.
Can you help us a little bit further on operating margin?
You talk about the operating margin gain in '05 and then the second half of this year we're going end up with flat operating margins.
And I know there are some negative near-term issues.
But can you talk about what's driving again the second half here and what changes in '05 that allows that margin improvement you have seen in the recent years to return.
- Chief Financial Officer, Sr. Vice President
Sure, Eric.
This is Bob Hull.
I think it stems largely from some of the pressures we're seeing on gross margin with the mix impact, with the negative impact associated with the hurricanes, which we don't fully will carry forward in 2005.
In fact, as Robert noted, as people fix the exterior of their homes, they typically start working on the interiors.
So we should get a mixed benefit from that in 2005.
Something else that's impacting Q3 and likely Q4 will be, um, impact of our merchandising initiatives.
Previously we've talked about the efforts in 2004 regarding 170 stores.
This includes updating the back of 120 stores and complete remerchandising for another 50 stores.
Both of these projects involve aligning adjacencies and really right-sizing the space for our furniture category.
When this happens, we end up with some markdowns and liquidation associated with cleaning out the old product and bringing in the new product.
This activity was up about 21% Q3 versus Q4.
It's really associated with this big remerchandising push that we've got going versus last year.
We would expect not to have an incremental increases in 2005 associated with this, so, it's largely these what, we believe is one-time margin pressures that are contributing to the operating margin pressure, the back half of this year that won't be repeated in 2005.
- Analyst
I guess within that, you've done a better job in leveraging SG&A this quarter the best we've seen in quite some time, is there anything strategically differently happening there, you've talked about what's going to change with distribution in the future?
But in the nearer-term and sustaining, can you do anything and are you doing anything different within that SG&A,equation
- Chief Financial Officer, Sr. Vice President
We've been -- put a quite a -- focused on SG&A all year long.
Larry Stone and his operations SVPs, have partnered with the finance organization, we've got a , kind of a regimented of process that we're evaluating every single line-item that has paid dividends in 2004 which we believe will continue in 2005.
So nothing significant, just a lot of little things we're doing to evaluate every single line.
- Analyst
Great, thank you.
- Chief Financial Officer, Sr. Vice President
Sure, Eric.
Operator, we have time for one more question.
Operator
Our final question comes from Bill Sims with Smith Barney.
- Analyst
Good morning, thank you.
Can you comment on the gross margin impact from you new lower pricing campaign and then as well, you've discussed about wanting to, attach more product to products under the new lower pricing campaign?
Can you comment on how the attachments are going?
Thank you.
- Chief Financial Officer, Sr. Vice President
Sure Bill.
This is Bob Hull.
I'll take the first part and let Dale take the second part.
Really, Bill, we're not seeing any margin impact from the new lower-priced strategy.
The intent basically is to, as we get, um, cost reductions from our vendors to pass them along to our customers, therefore maintaining the margin rate for that particular item so there is no impact associated with NOP on our margin rate.
- Senior Executive Vice President - Merchandising/Marketing
Yeah, Bill, first of all, you know, the new lower price program really isn't anything new from the standpoint of price reduction.
I mean we, any time we get a cost reduction from our vendors, it's not uncommon for us to take a look at it and so if we can drive more business, for example, a couple of years ago we had ceramic tile.
We sourced it from offshore vendor and we were able to take a pretty aggressive stamp on the, on the tile and drive that category, so, one, it's really more introducing that concept to the customer through our advertising and store signing, which in the past, without the benefit of systems support, we really had to do that manually.
Today, it's more automated, so we're able to take credit for the price decreases that we've actually -- or the cost decreases we have had and, therefore, pass that along to the customer.
It, it is working.
I mean it does drive traffic and I do think that it's a little bit of a contribution to our little bit of customer count increases that we saw.
And in some cases where we, where we get these price decreases, the price decreases really don't show up until the volume rebates kick in.
So that's another aspect of it.
Sometimes they're direct cost decrease on the item of the time share within the volume rebate.
So, hopefully that helps.
- Analyst
All right.
Thank you.
- Chairman, Chief Exec. Officer
Thanks, Bob and Dale.
As most of you know, after spending the last 42 years with Lowe's, I will retire at the end of this fiscal year.
This marks my last quarterly earnings call.
As I reflect on the past 42 years, I'm proud of what we have accomplished.
We have grown from a chain of 18 stores in 1962 to over 1,000 today.
Probably an even greater accomplishment is the fact that within the last decade, we have reinvented Lowe's, transforming from a regional chain of lumber and building material stores to the national big box home improvement company you see today.
To my knowledge, a successful transformation of this magnitude has never been accomplished in retail.
And could not have been realized without the hard work and effort of thousands of dedicated employees.
I would like to personally thank each of and every one of them for their hard work and loyalty to Lowe's.
As we end this call, I would like to reiterate my confidence in Robert's leadership and the team of executive management, who, with the help of over 160,000 employees, will ensure we are our customer's first choice for home improvement in each and every market we serve.
As I have said before, the time for change is when the sun is shining and based on the results we're delivering today, the sun is clearly shining on Lowe's.
As always, thank you all for your continuing interest in Lowe's and thanks for your support over the years.
Robert and the Lowe's team will report our fourth quarter results in February.
Thank you and have a great day.
Operator
This concludes today's conference call.
You may now disconnect.