The third quarter was marked by an extremely active hurricane season, with Hurricanes Katrina, Rita and Wilma impacting our operations, our customers and our employees. Following Hurricanes Katrina, Rita and Wilma, 35, 55 and 17 stores, respectively, were temporarily closed or operated under reduced hours due to damage or evacuation orders. Most stores reopened within 24 hours to help local residents repair their homes and begin rebuilding their communities. Only one location remained closed at October 28, 2005, which is our store in central New Orleans that is projected to re-open during the first week of December. Uninsured losses incurred as a result of hurricane-related damages were not material to our consolidated financial statements.
Our comparable store sales increase of 6.2% for the quarter was driven by consumers continuing to invest in their homes, strong performance in our specialty sales initiatives of Installed Sales, Special Order Sales and Commercial Business Customer sales, as well as increased sales in hurricane-affected areas. Comparable store sales for the third quarter were positively impacted by approximately 100 basis points as a result of the three hurricanes that hit the Gulf Coast and Florida. We experienced an increasing trend in comparable store sales increases during the quarter. In addition, 19 of our 21 regions delivered comparable store sales increases compared to third quarter 2004.
In the third quarter of 2005, our average ticket increased 8% to $68.81 and total customer transactions increased 8%. For the first nine months of 2005, average ticket increased 7% and total customer transactions increased 9%. Comparable store customer transactions decreased 1% compared the third quarter of 2004, with decreases in comparable store customer transactions in August and September due to hurricane activity and the potential impact of the resulting spike in gasoline prices. Comparable store customer transactions increased in October and that trend continued in November.
We experienced comparable store sales increases in all of our 20 product categories for the third quarter. We created a new product category in the third quarter, lawn and landscape products, which was separated from our nursery category. This new category includes garden chemicals, fertilizer, mulch and patio block. Inflation in building materials was partially offset by deflation in lumber, resulting in a net favorable impact on third quarter comparable store sales of approximately 25 basis points. The categories that performed above our average comparable store sales increase for the third quarter included millwork, rough plumbing, rough electrical, outdoor power equipment, appliances, paint, fashion plumbing, flooring and cabinets & countertops. In addition, building materials, home environment, and lawn and landscape products performed at approximately the overall corporate average comparable store sales increase for the third quarter. Appliances continued to perform well during the third quarter of 2005, with independent measures of market share indicating that we gained 190 basis points of unit share in major appliances in the third calendar quarter compared to last year. Outdoor power equipment continued its consistent sales performance, delivering double-digit comparable store sales increases in the third quarter, driven primarily by riding mower sales.
Gross Margin -The increase in gross margin as a percentage of sales compared to the third quarter of 2004 was primarily due to lower inventory acquisition costs, including the impact from additional imported goods, the positive impact from our Rapid Response Replenishment (R3) initiative and reduced inventory shrink. These items were slightly offset by negative product mix impact resulting primarily from hurricane-related sales and higher fuel prices.
The increase in gross margin as a percentage of sales for the first nine months of 2005 was primarily due to the impact of the implementation of EITF Issue No. 02-16 (EITF 02-16), “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” which reduced gross margin in the first nine months of 2004 as vendor funds associated with cooperative advertising and in-store services were capitalized into inventory and recognized in income when the product was sold. We also experienced an increase in gross margin as a percentage of sales resulting from improved inventory shrink.
SG&A- The decrease in SG&A as a percentage of sales in the third quarter of 2005 resulted primarily from decreases in store-services and advertising expense as a percentage of sales. Our ongoing evaluation of in-store vendor service expense has allowed us to appropriately adjust the level of vendor service in our stores, which led to the decrease as a percentage of sales. In addition, though there was an increase in advertising expense compared to the third quarter of 2004, we were able to enhance messaging and refine our marketing mix to make our advertising programs more productive, thereby resulting in the leverage of advertising expense as a percentage of sales. These items were partially offset by an increase as a percentage of sales in bonus expense, driven by strong sales and earnings performance. In addition, there were increases as a percentage of sales in store remerchandising expense, which resulted from our continued investment in existing stores, and rent expense, as we continue to expand into metropolitan markets.
For the first nine months of 2005, the key drivers of the increase in SG&A as a percentage of sales were also bonus and rent expense. These items were slightly offset by a decrease in gross advertising expense as a percentage of sales compared to the first nine months of 2004.
Store Opening Costs -Store opening costs, which include payroll and supply costs incurred prior to store opening as well as grand opening advertising costs, are expensed as incurred and totaled $35 million in the third quarter of 2005 compared to $32 million in the third quarter of 2004. These costs are associated with the opening of 33 new stores in the third quarter of 2005, as compared with the opening of 35 stores in the third quarter of 2004 (34 new and one relocated). Store opening costs for stores opened during the quarter averaged approximately $0.9 million per store in the third quarter of 2005 and $0.7 million in the third quarter of 2004. Because store opening costs are expensed as incurred, the expenses recognized in any quarter may fluctuate based on the timing of store openings in future or prior periods.
Store opening costs of $85 million and $71 million for the first nine months of 2005 and 2004, respectively, were associated with the opening of 87 stores in 2005 (84 new and three relocated), compared to 84 stores in 2004 (80 new and four relocated).
Depreciation - -Property, less accumulated depreciation, totaled $15.4 billion at October 28, 2005, an increase of 15.8% from $13.3 billion at October 29, 2004. This increase resulted primarily from our store expansion program, increased distribution capacity and our investment in information technology. Depreciation expense increased 11% and 13% for the three and nine months ended October 29, 2005, respectively, over the corresponding prior periods. Continued sales growth in excess of the rate of growth in property contributed to the leveraging of depreciation expense of six basis points for the nine months ended October 29, 2005.
Income Tax Provision -Our effective income tax rate was 38.5% for both the quarter and nine months ended October 28, 2005, compared to 38.6% and 38.5%, respectively, for the quarter and nine months ended October 29, 2004.
Initiatives Driving Performance
We continue to focus on our three specialty sales initiatives, which are Installed Sales, Special Order Sales and sales to Commercial Business Customers, to drive higher sales volume and comparable store sales increases. Installed sales performance in our comparable stores for the third quarter was consistent with the first and second quarters of 2005, with a comparable store sales increase above the company average. Our Special Order Sales initiatives also continue to perform well, delivering comparable store sales increases above the company average for the third quarter. Our special order sales are growing as consumers continue to seek unique products for their homes, aided by improved product visibility in our stores, simplified ordering processes and shorter order lead times. Finally, sales to Commercial Business Customers continue to grow, with comparable store sales increases above the company average for the third quarter, driven by our focus on strengthening customer relationships, targeted marketing and product selection.
During the third quarter of 2005, we continued to make progress in our R3 initiative, with the goals of improving customer service, optimizing supply chain profitability and improving inventory management. With respect to improving customer service, our goal is to improve in-stock levels and reduce inventory handling so our employees can focus on customer service. We have reduced lead-time by a full day as a result of improved infrastructure and processes. When we began the R3 initiative, approximately 50% of our product was shipped through our network of distribution centers. With the changes implemented as a part of R3, we are now shipping approximately 65% of our product through the network, and estimate this percentage to reach 70% by year end. Our goal is to reach 75% of product flowing through the network. As a result of increased regional distribution center (RDC) volume, the frequency of deliveries from our RDCs to our stores has increased from an average of four deliveries per week in the prior year to five deliveries per week in the current year. The increased frequency of store deliveries helps to reduce inventory handling and down-stocking at the stores.
Related to optimizing supply chain profitability, we have conducted a thorough review of the components of our supply chain, including handling, transportation and inventory carrying costs. We are focusing on minimizing these costs by evaluating pack sizes, receiving more full truckloads and decreasing vendor-direct shipments to our stores.
Regarding inventory management, we have taken a measured approach when implementing R3. Our goal is to have the right products in the right stores at the right time and as such, we have focused on ensuring that we have adequate quantities of items in stock.
Our third quarter inventory balance increased $749 million, or 13%, over the same period last year, compared to our 17% increase in sales for the third quarter. This increase in inventory was driven by the addition of 140 new stores and the opening of new distribution facilities since the third quarter of 2004, partially offset by a decline in comparable store inventory. At the end of the third quarter of 2005, comparable store inventory was 2.8% lower than the third quarter of 2004.
LIQUIDITY AND CAPITAL RESOURCES
The primary sources of liquidity are cash flows from operating activities and our $1 billion senior credit facility that expires in July 2009. Net cash provided by operating activities totaled $3.4 billion and $2.1 billion for the nine month periods ended October 28, 2005 and October 29, 2004, respectively. The increase in cash provided by operating activities resulted primarily from increased net earnings, combined with inventory leverage. Working capital at October 28, 2005 was $2.5 billion compared to $1.8 billion at October 29, 2004 and $1.3 billion at January 28, 2005. The increase in working capital from the third quarter of 2004 primarily resulted from the issuance of $1 billion in senior notes in October 2005.
The primary component of net cash used in investing activities continues to be opening new stores and investing in our distribution and information technology infrastructure. Cash acquisitions of fixed assets were $2.3 billion and $2.1 billion for the nine months ended October 28, 2005 and October 29, 2004, respectively. At October 28, 2005, we operated 1,170 stores in 49 states with 133.0 million square feet of retail selling space, representing a 13% increase over the retail selling space at October 29, 2004.
Net cash provided by financing activities was $559 million for the nine months ended October 28, 2005, compared to net cash used in financing activities of $1.1 billion for the nine months ended October 29, 2004. The change in cash flows from financing activities was primarily the result of proceeds from the October 2005 issuance of $1 billion in senior notes, combined with fewer repurchases of common stock under our share repurchase program compared to the nine months ended October 29, 2004. The ratio of long-term debt to equity plus long-term debt was 21.6%, 25.0% and 21.0% as of October 28, 2005, October 29, 2004 and January 28, 2005, respectively. In the fourth quarter of fiscal 2005, long-term debt totaling $608 million will mature. We plan on repaying this debt with the proceeds from our $1 billion senior notes issued in October 2005.
We have a $1 billion senior credit facility that became effective in July 2004 and expires in July 2009. The facility is available to support our $1 billion commercial paper program and for short-term borrowings. Borrowings made are priced based upon market conditions at the time of funding in accordance with the terms of the senior credit facility. The senior credit facility contains certain restrictive covenants which include maintenance of a specific financial ratio. We were in compliance with those covenants at October 28, 2005. Fifteen banking institutions are participating in the $1 billion senior credit facility. As of October 28, 2005, there were no outstanding loans under the facility and there were no outstanding borrowings under our commercial paper program.
From their issuance through the end of the third quarter of 2005, principal amounts of $444 million or approximately 44% of our February 2001 convertible debentures had converted from debt to equity. Of this total, $73 million and $434 million, respectively, in principal amounts were converted in the third quarter and nine months ended October 28, 2005.
In January 2005, the Board of Directors authorized up to $1 billion in share repurchases through fiscal year 2006. This program is intended to be implemented through purchases made from time to time either in the open market or through private transactions. Shares purchased under this program are retired and returned to authorized and unissued status. As of October 28, 2005 the share repurchase program had a remaining authorization of $505 million for common stock repurchases.
Our 2005 capital budget is $3.7 billion, inclusive of approximately $335 million of operating leases. Actual capital expenditures through the third quarter of 2005 and amounts forecasted through the end of fiscal 2005 are consistent with the 2005 budgeted amount. Approximately 78% of this planned commitment is for store expansion and our distribution centers. Expansion plans for 2005 consist of approximately 150 stores, including the three relocations of older stores that have already occurred. This planned expansion is expected to increase sales floor square footage by approximately 13%. Approximately 69% of the 2005 projects will be owned, 30% will be ground leased properties and 1% will be build-to-suit leases.
At October 28, 2005, we owned and operated 11 RDCs. We expect to open additional regional distribution centers in Rockford, Illinois and Lebanon, Oregon in 2007. In addition, we plan on expanding three existing distribution centers in Valdosta, Georgia, Statesville, North Carolina and North Vernon, Indiana by spring of 2006. We also operated 12 flatbed distribution centers for the handling of lumber, building materials and other long-length items, of which 10 were owned. We expect to open four additional flatbed distribution centers in 2006.
We believe that net cash provided by operating activities and financing activities will be adequate for our expansion plans and other operating requirements over the next 12 months. However, the availability of funds through the issuance of commercial paper and new debt could be adversely affected due to a debt rating downgrade or a deterioration of certain financial ratios. There are no provisions in any agreement that would require early cash settlement of existing debt or leases as a result of a downgrade in our debt rating or a decrease in our stock price. Holders of the $580.7 million Senior Convertible Notes may convert their notes into common stock if the minimum investment grade rating is not maintained. There is no indication that we will not be able to maintain this minimum investment grade rating. In addition, if a change in control of the company occurs on or before October 2006, each holder of the Senior Convertible Notes may require us to purchase for cash all or a portion of such holder’s notes. Additionally, during the third quarter of 2005, our closing share prices reached a specified threshold such that the Senior Convertible Notes became convertible at the option of each holder into shares of common stock at the beginning of the fourth quarter of 2005. Through February 3, 2006, holders may elect to convert each such note into 17.212 shares of common stock. We may redeem for cash all or a portion of the notes at any time beginning October 2006, at a price equal to the sum of the issue price plus accrued original issue discount and accrued cash interest, if any, on the redemption date. Our debt ratings at October 28, 2005, were as follows:
Current Debt Ratings | | S&P | | Moody’s | | Fitch | |
| Commercial paper | | | A1 | | | P1 | | | F1+ | |
| Senior debt | | | A+ | | | A2 | | | A+ | |
| Outlook | | | Stable | | | Positive | | | Stable | |
OFF-BALANCE SHEET ARRANGEMENTS AND OTHER CONTRACTUAL OBLIGATIONS
There has been no material change in our contractual obligations other than in the ordinary course of business since the end of fiscal 2004. Though considered to be in the ordinary course of business, in October 2005, we issued $1 billion in senior notes, which are included in the table below and further described in Note 6 to the unaudited consolidated financial statements herein. See the Annual Report for additional information regarding our off-balance-sheet arrangements and other contractual obligations.
| | | Payments Due by Period | |
| Contractual Obligations | | | | Less than | | 1-3 | | 4-5 | | After 5 | |
| (In Millions) | | Total | | 1 year | | years | | years | | years | |
| Long-term Debt (principal and interestamounts, net of discount) | | $ | 7,140 | | $ | 799 | | $ | 387 | | $ | 821 | | $ | 5,133 | |
COMPANY OUTLOOK
Fourth Quarter
As of November 14, 2005,the date of our third quarter 2005 earnings release,we expected to open 63 stores during the fourth quarter of fiscal 2005, which ends on February 3, 2006, reflecting square footage growth of approximately 13%. Total sales were expected to increase approximately 22%. Comparable store sales were expected to increase 4% to 6% (as compared to a comparable 14 weeks). We expected diluted earnings per share of $0.77 to $0.80. Unless otherwise noted, all comparisons are with the fourth quarter of fiscal 2004, a 13-week quarter.
Fiscal 2005
As of November 14, 2005,the date of our third quarter 2005 earnings release,we expected to open 150 stores during fiscal 2005, which ends on February 3, 2006, reflecting total square footage growth of approximately 13%. Total sales were expected to increase 17% to 18% for the year, while comparable store sales were expected to increase 5% to 6% (as compared to a comparable 53 weeks). We expected diluted earnings per share of $3.37 to $3.40. Fiscal 2005 will include an extra week in the fourth quarter for a total of 53 weeks. Unless otherwise noted, all comparisons are with fiscal 2004, a 52-week year.
FORWARD-LOOKING STATEMENTS
This Form 10-Q contains "forward-looking statements" within the meaning the Private Securities Litigation Reform Act of 1995 (the “Act”). All statements other than those reciting historic fact are statements that could be “forward-looking statements” under the Act. Such forward-looking statements are found in, among other places, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Statements containing words such as “expects,” “plans,” “strategy,” “projects,” “believes,” “opportunity,” “anticipates,” “desires,” and similar expressions are intended to highlight or indicate “forward-looking statements.” Although we believe that the expectations, opinions, projections, and comments reflected in our forward-looking statements are reasonable, we can give no assurance that such statements will prove to be correct. A wide variety of potential risks, uncertainties, and other factors could materially affect our ability to achieve the results expressed or implied by our forward-looking statements including, but not limited to,changes in general economic conditions, such as interest rate and currency fluctuations, rising fuel costs, and other factors which can negatively affect our customers as well as our ability to: (i) respond to decreases in the number of new housing starts and the level of repairs, remodeling, and additions to existing homes, as well as general reduction in commercial building activity; (ii) secure, develop, and otherwise implement new technologies and processes designed to enhance our efficiency and competitiveness; (iii) attract, train, and retain highly-qualified associates; (iv) locate, secure, and develop new sites for store development; (v) respond to fluctuations in the prices and availability of services, supplies, and products; (vi) respond to the growth and impact of competition; (vii) address legal and regulatory matters; and (viii) respond to unanticipated weather conditions. Additional information regarding the risks and uncertainties which may affect our operations and economic results can be found in our filings with the Securities and Exchange Commission.
The forward-looking statements contained in this Form 10-Q are based upon data available as of the date of this report or other specified date and speak only as of such date. We expressly disclaim any obligation to update or revise any forward-looking statement, whether as a result of new information, change in circumstances, future events, or otherwise.
Item 3.- Quantitative and Qualitative Disclosures about Market Risk
The Company's market risk has not changed materially since January 28, 2005.
The Company's management, with the participation of the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s “disclosure controls and procedures”, (as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)). Based upon their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of October 28, 2005, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
In addition, no change in the Company’s internal control over financial reporting occurred during the fiscal quarter ended October 28, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II - OTHER INFORMATION
Item 2. -Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
| (In millions, except averageprice paid per share) | | Total Number of Shares Purchased (1) | | Average Price Paid per Share | | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2) | | Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs | |
| | | | | | | | | | |
| July 30, 2005 - August 26, 2005 | | | 1.7 | | $ | 64.23 | | | 1.7 | | $ | 593 | |
| August 27, 2005 - September 30, 2005 | | | 1.4 | | | 64.58 | | | 1.3 | | | 505 | |
| October 1, 2005 - October 28, 2005 | | | - | | | - | | | - | | | 505 | |
| | | | | | | | | | | | | | |
As of October 28, 2005 | | | 3.1 | | $ | 64.39 | | | 3.0 | | $ | 505 | |
| (1) | During the third quarter of fiscal 2005, the Company repurchased an aggregate of 3,041,400 shares of its common stock pursuant to the repurchase program publicly announced on January 28, 2005 (the “Program”). The total number of shares purchased also includes a nominal amount of shares repurchased from employees to satisfy the exercise price of certain stock option exercises. |
| (2) | On January 28, 2005, the Board of Directors approved the Program under which the Company is authorized to repurchase up to $1 billion of the Company’s common stock. The Program expires at the end of fiscal year 2006. |
Index
Exhibit 31.1 - Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended
Exhibit 31.2 - Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended
Exhibit 32.1 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 - Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Index
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| | LOWE'S COMPANIES, INC. |
| | | |
| December 6, 2005 | | /s/ Matthew V. Hollifield |
| Date | | Matthew V. Hollifield |
| | | Senior Vice President and Chief Accounting Officer |
| | | |
