EUR 850.00 For Business Accounts Only

Morningstar | Lowe’s Continues to Clean House Under New Leadership Team; Shares Fairly Valued

New CEO Marvin Ellison has kicked the assessment of Lowe’s into high gear, making significant changes to the business in his past four months at the helm. Starting with the decision to shutter Orchard Supply in August (99 stores), restructuring has escalated into the third quarter with the October announcement of 50 incremental store closures (30 of which are Canadian locations) and the exodus of its Mexico business (around 10 stores), which is currently seeking strategic alternatives. Furthermore, the company’s focus is now pivoting to the core business, as it exits smaller incremental efforts including Alacrity Renovation Services and Iris Smart Home. All in, these efforts are set to cost the company around $1 billion in impairments, accelerated depreciation, severance, and other wind-down-related costs, but we think are set to help refocus a refreshed management team in reinvigorating the brand intangible asset (source of its wide moat), ultimately helping bolster the operating margin from existing levels after incurring some near-term pain.

That said, efforts come at a time when housing indicators appear to be slowing, with eight of the last nine months delivering existing home sales declines and a rising interest-rate environment hampering affordability, particularly at the low end of the market. We have already factored this into our long-term outlook, which calls for comp store growth that averages 2.5%, revenue growth of 2.7% and operating margin that rises to 11% at the end of our forecast, still trailing the mid-teen level we expect at wide-moat Home Depot. Given that updated full-year adjusted guidance is largely in line with our prior $5.19 forecast (at $5.08-$5.13), we don’t plan to materially alter our $94 intrinsic value and view shares as fairly valued, trading at 14 times our 2019 estimate with 13% earnings per share growth embedded in our outlook over the next five years.

Third-quarter comps were disappointing, landing at 1.5% (on top of 5.7% in last year’s third quarter), widely trailing our 3.4% forecast and the 4.8% comp that Home Depot was able to achieve in its third quarter. Comps decelerated over the quarter, with August posting 4%, September clocking 0.7% and October flat, although we note the latter two months were particularly strong in 2017 due to hurricane-related purchases. Sales came in line with our estimate, however, rising around 3.8%, thanks to still robust spending in a slowing (but still positive) home improvement category; from our perspective, this allowed Lowe’s to take incremental market share in the period, while building materials and garden equipment and supplies dealers industry experienced just 3.2% growth on average (Census). The gross margin was 100 basis points worse than we anticipated, at 32.5%, decelerating more than 150 basis points, despite a 107-basis-point benefit from the adoption of new revenue recognition accounting standards. Inventory rationalization was the biggest drag on gross margin, followed by clearance activity, along with Orchard Supply wind-down headwinds and product mix.

As a result of a relatively weaker than anticipated quarter, the company’s full-year outlook was tempered, now expecting 4% sales growth (versus our 4.5% estimate, implying around 2% growth in the fourth quarter), 2.5% comp growth (versus our 3.2% estimate prior, implying around 2% comps for the fourth quarter) and adjusted EPS of $5.08-$5.13 (versus around $5.20 implied prior). While we don’t generally view lower outlooks favorably, we do believe this is a function of management resetting the business more favorably and anticipate more stable revenue and expense growth in mid-2019, once some of these periphery businesses are unwound and new supply chain and inventory initiatives are underway. Much of the commentary surrounded institutionalizing processes that were inefficient at the firm, including labor management, reset efforts and inventory controls, all which could squeeze meaningful operating margin expansion out of the business if they are implemented properly and were as unproductive as were described. As noted above, these initiatives will take time to implement, but should begin to take hold part way through 2019. Until then, we could see some volatility in GAAP earnings per share growth, with the still uncertain conclusion of the Mexico business and efforts to improve the core just kicking off now.